Project M 15 Multiplying Investment, Insurance & Knowledge by Ngoc Le-Tümmers

Multiplying investment and retirement knowledge

#15 K ING N I H T R E R EM EN T R ETI challenges and voalare s

antee raphic Demog ets mean guar ath to an k tile mar g scarcer. The p ement in retir m o c be ome in red. c in e t a e a d e qu reconsid must be With guarantees increasingly hard to find, protecting investments comes at a price.

MICRO

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META

(T he o ut s id e r ’ s v ie w )

The case of the writer who fell in love with India Tarquin Hall’s fictional Indian detective investigates curious cases in Dehli. 63

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GUARANTEED RESULTS A changing economic climate has intensified the need for securing assets for life in retirement. Institutions and investors, however, find it increasingly difficult to deliver the desired hard guarantees. Is it time to reconsider the path to an adequate retirement income?

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Is sues in depth

FOCUS Kyrgyz nomads in Afghanistan live a testing life filled with uncertainty, constantly searching for the right landscape and resources to support themselves.

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A Kyrgyz boy wears a makeshift mask to protect him from biting winds. Below a group of Kyrgyz men prepare for the life-changing event of a nomad wedding.

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spiring copywriters are told that ‘guarantee’ is one of the most dangerous words in their lexicon. Even when not used in a strict legal sense, the word is so laden with expectations that, if not deftly handled, it can later ensnare its user. Politicians and plan sponsors know the problem all too well. Even when not explicitly guaranteed – and many explicit guarantees have been made – past pension promises have returned to bite governments and corporations. Such commitments were originally intended to buy social harmony or quell industrial action by unionists demanding the same perks as management. Today they have grown to be significant burdens on states and overwhelm struggling companies. Governments have responded with reforms that ratcheted back state pension ‘promises.’ Calculations in 2009 show lifetime benefits paid in the 16 OECD countries that introduced the most wide-ranging reforms have now been cut on average by 22% for men and 25% for women (Filling the Pension Gap, 2009). But it was the financial crisis that underlined the stress that funded pension provisioning systems are under. At year-end 2008, global pension assets stood at €20 trillion; down by roughly 15% from year-end 2007 (€23.2 trillion). Towers Watson reported in January 2013 that global pension fund assets have recovered and reached a new high of $30 trillion. Yet, this is little consolation for individual workers, particularly in the United States, who watched their pension fund portfolios shrivel from 2007 to mid-2009. While younger workers will recover assets over their working life, the decline was traumatic for employees within striking distance of retirement. With little time to make up withered savings, they have either retired with substantially less than planned, or delayed retirement. SEEKING SECURITY Given events, it is understandable that clients, both individuals and institutional, seek some hard assurance that pension assets will be protected. Yet, what they are likely to get is softer guarantees, not harder. The desire for certainty comes at a time when states and corporations are withdrawing from providing guarantees – that dangerous word again – on the amounts they will contribute towards an individual’s retirement income. However, this does not mean clients are left alone and exposed to capital market volatility. Consumer protection laws and regulations exist to shield clients by specifying where and how entities can invest their assets. In particular, the introduction of fair-trade principles is seen as bringing greater transparency and consistency to financial

statements. These principles require companies (such as insurers) and institutions (such as pension funds) to measure and report assets and liabilities (generally financial instruments) at estimates of the prices they would sell or pay for the assets if they were relieved of the liabilities. Under fair-value accounting, also known as ‘mark-tomarket,’ losses are reported when the values of assets decrease or liabilities increase. With a common valuation applied across companies, it is argued that investors and consumers gain better information on the financial state of various institutions. Fair valuation is at the core of risk-based funding and solvency regulations in many countries as they relate to pension funds. More regulations are also being considered, specifically in the form of the Solvency II framework for European insurers.

» WITH LITTLE TIME TO MAKE UP WITHERED

SAVINGS, THEY HAVE EITHER RETIRED WITH SUBSTANTIALLY LESS THAN PLANNED, OR DELAYED RETIREMENT.

Critics of fair value argue that, among other points, reported losses can adversely affect prices, resulting in greater volatility that increases the overall risk of the financial system. This was seen during the financial crisis of 2008-2009 when write-downs lead to a rapid spiraling down of value as assets were sold at ’fire sale’ prices. This in turn lead to contagion as many entities competed to offload assets at ever lower prices. These claims are often flung around with little evidence, so they may be overstated. However, what is beyond dispute is the fact that changes in funding regulations and accounting standards have driven employers to minimize their pension promises. They have insured away obligations, realigned investment portfolios and passedthe-buck in terms of retirement income onto employees with the move from defined benefit to defined contribution pensions. Amongst insurers, the introduction of risk-based solvency rules in Switzerland is seen as a key factor behind the significant move away from equity allocations into government bonds in the last decade. A similar development was seen in Japan in 2006 after the introduction of asset liability management (ALM) strategies amongst life insurers. Other factors are also at play, notably a lessening in risk appetite after the financial crisis. However, it is feared

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further risk-based solvency rules will indirectly hasten the demise of guarantees in favor of promises and products based on payoffs based on market events (see the article ‘Raise your buffers’ on long-term pension investment strategies on pages 14-15). FORGETTING DECUMULATION Much of the concern about retirement asset protection is focused on the accumulation phase of life. Notably less attention is being paid to the decumulation phase and this is the big bind about protection. Protection is no great help if its implementation means savers will fall short of their ultimate goal: an adequate retirement income. If governments seeking to protect savers restrict investment risks, or make changes that will restrict investment risk, they could actually be exposing savers to the biggest risk of all: inadequate retirement assets. While experience shows that the average person would be naïve to expect capital markets to benignly provide for them (see Sheila Bair, former FDIC chairperson, pages 22-24), it should not be forgotten that risk pays a premium. This premium could potentially generate funds individuals need to help bridge the retirement shortfall. After all, the same market dynamics responsible for destroying so much savings in 2007-2009 also created much of that wealth in the decade previously. It seems, then, the notion of retirement needs a rethink, particularly concerning how pensions, guarantees and risk mesh together. With demographic trends running against developed countries and strong volatility of capital markets a given, we seem to be entering an era where fewer, not more,

guarantees could be expected. But if guarantees are not the answer, what is? Perhaps it is the indexing approach adopted by the Netherlands (pages 34-35), traditionally one of the developed world’s foremost pension thinkers. Oxford university professor Gordon L. Clark suggests the word ‘guarantee’ itself could be redefined so the underlying pension contract would become less binding. Instead, changing conditions should be taken into account and future guarantees would allow for rolling variations of guaranteed returns (see pages 31-33). Walter White (pages 19-21) believes guarantees still have a genuine place in any individual’s retirement strategy through annuities. Risk can be reduced and guarantees locked in, if financial professionals leverage the ‘Transition Period’ – the five to 10 years prior to the retirement date – to secure income streams and help reduce the risk losses shortly before retirement. That is one approach. Don Ezra and Keith Ambachtsheer make a similar point in the Conference Call (pages 16-18) about how pools of retirement savings should be treated differently during different phases of an individual’s lifecycle. Perhaps this will eventually morph into an approach that examines all asset sources: private, state and occupational, and allow a similar investment approach to portfolio assets. And, of course, education and well-designed default options have a part to play. None of these approaches alone will provide a single silver bullet to solve the problems plaguing retirement. Combined, they could still ensure the millions of individuals can still expect adequate, safe and sustainable retirements in the decades to come – even if it is not exactly guaranteed.

S L OW R E C OV E RY Trends in pension fund assets in selected countries with large mature markets, 2001-2011 As a percentage of GDP 160,0 Netherlands

140,0 120,0

Switzerland

100,0

Australia1 United Kingdom

80,0

United States Chile Denmark

60,0 40,0

Japan 2

20,0 0,0 2001

2002

Source: OECD Global Pension Statistics.

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2004

2005

2006

2007

2008

2009

2010

2011

1: Data refer to the end of June of each year. 2: Source: Bank of Japan.

Kyrgyz families work hard to prepare for harsh winters spent in yurts. Children often start working at a very young age and remain active for most of their lives.

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RAISE YOUR BUFFERS Stringent solvency requirements for pension providers are currently benched and in need of overhauling, a risklab study suggests.

he pension industry breathed a collective sigh of relief in May as European regulators dropped a bid to apply higher capital requirements to pension funds. Michel Barnier, the European commissioner for internal markets and services, postponed the implementation of pillar one of the revised Institutions for Occupational Retirement Provisions (IORPs) directive, stating that the Commission needs time to collect more data. Capital rules, known as Solvency II, require insurance companies to put aside more capital to withstand future financial crises. The rules aim to make insurers safer by obliging them to hold capital reserves in proportion to the risk they take. Taking industry concerns about disparate regulatory premises for insurers and

IORPs into account, European regulators were planning on applying the same capital rules to funded pension schemes. MAKING LIFE HARDER The proposal leaves many experts worried, including the authors of the risklab study Long-term Pension Investment Strategies under Risk-based Regulation. “The amount of capital a pension fund needs as buffer to pursue even a moderate, much less an aggressive investment strategy, would balloon,” Christian Schmitt, one of the study’s authors, tells PROJECT M. The new requirements would lead to a substantial increase in the value of liabilities that need to be covered by a higher amount of assets to bolster any risk of asset fluctuation or solvency capital requirements (SCR). The

Solvency requirements for pension providers will create an environment of pressure and restraint.

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THE WHOLE PENSION PLAN WOULD BECOME A VERY EXPENSIVE ENDEAVOR FOR THE CORPORATE SPONSOR. CHRISTIAN SCHMITT

FURTHER READING Download the full study from www.risklab.com

proposed regulation’s incentive would be to invest in a liability-matching portfolio, in which assets have a comparable maturity to liabilities, which would in turn act to reduce risk capital requirements. In their current format, the Solvency II-like quantitative requirements would make life harder for the pension fund chief investment officer. “They would significantly limit the range of investment strategies a portfolio manager can pursue,” says Schmitt. The study carried out by risklab, a quantitative capital-market research firm owned by Allianz Global Investors, assessed the potential impact of the proposed requirements on long-term investment behavior. The researchers tasked themselves with looking at the regulation’s effect on the liability valuation and risk-based funding requirement of a fictitious pension fund. The fund was assumed to have both a generic pension plan and asset allocation. Within the scope of the proposed holistic balance sheet approach (an attempt to also value other security mechanisms, such as the sponsor covenant as assets), it examined the effect on typical occupational pension plans and on various asset classes. The study takes three typical portfolios for European occupational pension funds: a conservative portfolio, a moderate one and an aggressive one. In all cases, the portfolios were found to be heavily under-funded under the proposed requirements. RISK OF HERDING BEHAVIOR Certain asset classes would be hit harder than others, the study shows. Government bonds, infrastructure, private equity and emerging market bonds would become more attractive to pension funds. Others, namely alternative assets, hedge funds or commodities, less so. The research suggests that long-maturing government bonds would bring the least risk if you were to invest in just one asset class, says co-author Gerhard Scheuenstuhl. While market effects were outside of the study’s scope, big pension funds buying into the more attractive asset classes are likely to push up their prices and thus distort the market. “As prudent investors would put

together their investment to favor, for example, private equity over commodities, the regulation promotes a less than ideal portfolio composition,” he adds. According to the risklab findings, the proposed changes would be a heavy burden on the pension funds and possibly also for corporate sponsors, who would be forced to set aside a risk buffer which – in today’s typical asset portfolios – could reach more than 50 cents for every euro invested. Sponsors unable to afford such a strong safety net might be pushed into safer portfolios at the cost of lower expected returns, which further increases their funding gap over time. NEGATIVE IMPACTS “The whole pension plan would become a very expensive endeavor for the corporate sponsor and many would want to quit as soon as possible,” Schmitt says. Some might even experience negative side effects on their operational businesses. To ease the burden, many corporate sponsors are likely to move from defined benefit (DB) to defined contribution (DC) plans, hastening the general trend towards DC. Retirees couldn’t fully relax either. “With corporate sponsors financially overstretched by regulation, pension benefits may be lower in the long run,” adds Scheuenstuhl. “If a company were to go bankrupt, it would default on pension contributions and benefits provided by the pension protection fund may be far less generous.” Governments, meanwhile, could console themselves with the thought that the new requirements make current pension systems safer and provide a consistent regulatory framework throughout Europe. In the long run, governments might also suffer as the financial burdens added to employees under DC systems created welfare problems. Ultimately, there is concern that solvency rules could stifle rather than encourage true long-term investment from all sides. The proposals could cost the industry in total, thwarting their ability to invest. Rethinking the IORPs directive seems a wise step on the way to regulation that provides a truly level playing field to all pension players.

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SOLVENCY WHO? The response to a question on Solvency II was coincidentally one of the most enlightening of the interview. “What’s that?” asked a leading researcher on Asian pension reforms, Donghyun Park.

ark ’s answer reveals the gap between preoccupations in Western countries and in Asia. Heated controversy in Europe surrounding Solvency II – regulations defining the capital insurance companies must hold to reduce the risk of insolvency and its application to the pension fund industry – barely amount to parish-pump politics when viewed from Asia, where the private pension fund industry is still in its infancy. It is not that Asia does not learn from experiences elsewhere. Rather, the pension systems there confront dramatically different situations, responds Park, principal economist at the Economics and Research Department of the Asian Development Bank, when Solvency II is explained. “In recent decades, Asia has been exceptionally successful in terms of economic growth, but everything in Asia is happening at rocket speed. What has taken centuries in Western countries is taking place in a compressed time frame of decades in Asia,” he says. Park refers specifically to demographic aging. Many Asian societies are rapidly becoming older. As societies become more mobile, urbanized and structured around the nuclear family, traditional notions of filial support are undermined. A LONG WAY TO GO “We do not yet have mature, sophisticated pension systems. Even advanced Asian nations, such as South Korea, only introduced a national public pension system in 1988, while middle-income nations, such as Indonesia and Thailand, are still in embryonic stages. We really have a way to go before worrying about systemic design.” Park sees the governance and administration of Asian pension systems as areas needing critical improvement. “The core functions of any system – collecting

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contributions, maintaining data, paying benefits in a timely and reliable way – are underdeveloped, as are equally important systemic features such as contribution rates, adequacy and sustainability.” Park, the editor of the Routledge book Pension Systems and Old-Age Income Support in East and Southeast Asia (2012), says there is no difference in the way citizens in developed nations and developing Asian countries view the “pension promise.” SUSTAINABILITY IS KEY “In both they believe the government is the ultimate guarantor of pension benefits. There is a belief that governments will deliver on the benefits 20 years down the road in exchange for contributions made today. However, Asians are perhaps slightly more skeptical and willing to save more on their own, given the plight Western pensions systems are experiencing.” He adds a positive for Asia is that, being latecomers, they can learn from advanced nations that the most salient feature of a pension system is sustainability. “Sure, there are trade-offs between affordability, adequacy and sustainability, but this is more apparent than real. At the end, if a pension system is not sustainable there will be no payouts – let alone adequate ones – to anyone.”

F U R T H E R I N F O R M AT I O N Read the article ‘A country for old men’ in PROJECT M #03 to learn more about how changing demographics in South Korea place the nation on the front line of the Asian pension debate. For more on Donghyun Park and the Asian Development Bank, see: www.voxeu.org/person/donghyun-park

Learning from the West? Copycat village Hallstatt offers a taste of Austrian lifestyle â&#x20AC;&#x201C; in China.

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CONFERENCE CALL: GUARANTEED? Since the f inancial crisis, guarantees have become a vexatious topic for all parties involved in pension discussions. Dirk Hellmuth discusses the topic with Don Ezra and Keith Ambachtsheer, who are not only t wo revered senior statesmen of the industr y, but also old friends.

T O RO N T O Canada

N E W YO R K United States

M U N I C H Germany

Keith Ambachtsheer Director, Rotman International Centre for Pension Management, Rotman School of Management, University of Toronto Keith is adjunct professor of finance, academic director of the RotmanICPM Board Effectiveness Program, and publisher and editor of the Rotman International Journal of Pension Management. His firm, KPA Advisory Services, has provided advice to government, industry associations, pension-plan sponsors, foundations and other institutional investors since 1985.

Don Ezra Co-chair of global consulting for Russell Investments worldwide Don is a member of the investment committee of a charitable trust and a fellow of the American Savings Education Council. He is also a widely published author. In addition to a number of articles and papers, his books include Understanding Pension Fund Finance and Investment (1979) and The Retirement Plan Solution: The Reinvention of Defined Contribution (2009).

Dirk Hellmuth CEO, All Net GmbH, Allianz International Employee Benefits Network Within Allianz Global Life, All Net provides international clients with corporate life, pension and health solutions. The unit assists corporate clients in the coordination and implementation of their international employee benefits plans.

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Hellmuth: Don, Keith – thanks for joining us. What is your stance on guarantees as they relate to pensions and retirement systems? Ezra: We have to be realistic about costs. Across the globe, actuaries and providers of guarantees have used all kinds of mechanisms to conceal the costs of the guarantee. Ambachtsheer: Another point is that traditional DB systems gave guarantees to people regardless of their need, that is, at a point when the guarantee was irrelevant. Trying to give a 25-year-old a payment guarantee 45 years down the road is a rather silly concept. You probably can’t hedge it, and it doesn’t meet the needs of the individual. Hellmuth: The problem is that the collective interest in providing retirement benefits is often at odds with the collective interest in sustaining employers and industries. In the last decades, pensions reforms have resulted in a shift from strong first pillar (state) focused systems to second (occupational) and third (private) pillar focused. We have to rethink the multipillar model as an integrated system to balance out the risks of all stakeholders – governments, companies and individuals – to arrive at an acceptable level of overall risk, while achieving adequate income levels. This means moving away from the blackand-white duality of DB/DC, where one partner – the sponsor in the case of defined benefit, the member in defined contribution – bears all risks. Defined ambition (DA) is interesting, as it shares risks between sponsors and members. Ambachtsheer: Deductively, there is no good way for employees and employers to share risks in a sustainable, transparent way, so let’s not even try. This is best understood from the John Nash game theory perspective. His theory relates to guarantees, as it predicts that the kind of DB pension arrangements created in the 1970s and 1980s would eventually become winlose situations because you don’t have the contracting power and vision to maintain what you started through tough times. What happened with occupational and state pensions in 2000 and beyond proves this. Discussing guarantees, the question is: what kind of legal and economic arrangements do you need for a guarantee to really be a guarantee? A guarantee provider needs enough

capital behind the promise to make good on it. For example, in the United States, TIAA-CREF (Teachers Insurance and Annuity Association – College Retirement Equities Fund) has operated in that way for many decades. There is a clear distinction between people accumulating assets to seek high returns – the CREF part – and then having the opportunity to buy annuities at fair value – the TIAA part. Ezra: Dirk, you are right, we can do better than pure DB and pure DC. People have different needs. Younger people are more proaccumulation, and older people are more procertainty. This reflects goals we have in life: to survive and to thrive. How we split resources between survival and thriving varies. In a pension context this survival role is important when you don’t have much time on your side. The older you are the more you want to make sure with those guarantees. The younger you are, the more flexibility you want. You want to say, “OK, let’s accumulate as much as possible.” When it comes to retirement, the question arises of how big are the pools to which you can allocate these risks? Distinction between the pension pillars becomes important. In the first pillar you get the whole nation sharing one pool. But in the second pillar, we have pools where you can distinguish between the goals of procertainty and pro-accumulation. I like an idea Keith often talks about, having two pools. A pool for younger savers, one for older savers and a transition pool in between. Hellmuth: Is that the reality, though? Ezra: Well, we are geeks, even though I try to be an educational geek. Guarantees are dominated by technicians, they are designed by actuaries, and we have done a poor job of educating people. There are few guarantees in life. However, if you think of crossing the road, driving a car or riding a bike, people are willing to try to reduce risk – by wearing a bike helmet or seat belt, or crossing the street carefully. We do this because we understand the risk. The reason we want guarantees in pensions is because we are afraid that if we don’t have them we don’t know what to do. There is fear of the unknown. We can educate people to understand the unknown so they won’t fear it as much and will be willing to live without a total financial guarantee.

GUARANTEES ARE DESIGNED BY ACTUARIES, AND WE HAVE DONE A POOR JOB OF EDUCATING PEOPLE. DON EZRA

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Ambachtsheer: Trust is crucial. Look at the Finnish system. It’s complicated, but the society shows high levels of trust. People are willing to let the geeks run the system – if they trust that they are creating a long-term, fair and sustainable system. The Nordic countries, including the Netherlands, have a collective process for doing that. They have three representative groups: employees, employers and taxpayer representation through the government, involved in ongoing discussions including heavy technical stuff. The results work for people, so they trust the system. Ezra: And the Nordics are also at the top of the list in surveys of self-proclaimed citizen happiness. You can’t find the same feeling of being in this together in the UK or the US. Ambachtsheer: We also have to be clear about property rights. Employment-based DB plans have all too often obscured those rights. Essentially, there should be no wealth transfers allowed. Clear property rights are especially important in the Anglo-Saxon countries, that is, you want to understand what you own, but it is not the same in all cultures. For example, the notions of solidarity and collective rights have more traction in the Nordic countries. Hellmuth: How optimistic are you that we will achieve this level of transparency? Ambachtsheer: That will be difficult unless we correct the informational asymmetry where the service sellers know more about what they are selling than the buyers know about what they are buying. It relates back to George Akerlof and his work on The Market for Lemons in understanding how well or poorly a market works. Unless you create mechanisms on the buy side of the financial service industry to correct informational asymmetry, you’ll have a problem with transparency and costs. Hellmuth: Do you expect guarantees to disappear, as Gordon Clark has suggested (see page 31)? I cannot believe that guarantees are going to become extinct. Some form of guarantee will remain as part of the pension product package available to individuals. Ezra: Humans do better in groups than individually, and that is why we need some notion of risk sharing. In the first pillar, I don’t expect guarantees to disappear, simply because we get the politicians we deserve. And we choose

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those politicians that promise us everything – with the possible exception of the Nordic countries. In pillar three, it is all about education – not selling. It is an educational issue and a big passion of mine. For the second pillar, I think Keith’s idea of two pools with a transition between them is constructive. This is my guess on the future of guarantees. Ambachtsheer: I believe NEST (National Employment Savings Trust) in the United Kingdom is an important venture. NEST has good governance and management, and fits nicely with Britain’s move towards defined ambition pension arrangements, which can include a payment guarantee dimension. Regarding emerging markets, I think even in developed economies we haven’t figured out how to use guarantees well yet, so why should we expect developing economies to get it right? And first and foremost to me is to get the property rights of pensions well-defined. This is still a major challenge in some countries, as we have seen in Hungary, for example, where pension savings were nationalized in 2010. Ezra: I would go further. Don’t provide guarantees. A lesson of the last six years is that countries we thought could provide guarantees are not able to. So the notion of risk-free, which needs to be associated with the notion of guarantee, has to go. Hellmuth: Will insurance companies be able to provide guarantees? Ambachtsheer: To the degree insurance companies are able to do the right calculation at what price they are willing to issue what guarantee, there will definitely be a business. The interesting question gets back to industrial structure: to what degree should you/can you mutualize that need for certainty, and to what degree should/can it be supplied by commercial providers. Hellmuth: Insurance companies should not only focus on providing a guarantee. Combining wealth management and insurance products can address two types of uncertainty: how much savings the individual can build up preretirement and how long the individual will live post-retirement. Gentlemen, I am sure this is far from the last word on guarantees. Thank you, it has been a pleasure.

WE HAVEN’T FIGURED OUT HOW TO USE GUARANTEES WELL YET, SO WHY SHOULD WE EXPECT DEVELOPING ECONOMIES TO GET IT RIGHT? KEITH AMBACHTSHEER

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A TRANSITIONAL BOOM TIME Why utilizing the retirement transition period is critical for the baby boomer generation, to ensure guaranteed retirement income – and keep their ‘golden years’ golden.

By Walter White, President and CEO, Allianz Life Insurance Company of North America

etirement income planning is the new buzz in the financial media, with many financial professionals and baby boomers more focused on the need for a secure stream of income in retirement than on a large nest egg at retirement. As 10,000 baby boomers reach retirement aged 65 each day in America – a trend that will last well into the next decade – understanding this distinction has never been more important.1 The financial services industry, however, has struggled with providing consumers a

meaningful way to secure retirement income. Instead of embracing approaches that reduce risk and lock in guarantees earlier in the planning process, the industry remains tethered to old ideas where these guarantees – if offered at all – can wait until the point of retirement. This is a problem. Unexpected down markets just prior to retirement can devastate plans, as many people experienced during the 2008-2009 financial crisis. Instead of waiting, boomers and their financial professionals

WA LT E R W H I T E President and CEO of Allianz Life since 2012, Walter White previously held leading roles at MONY Brokerage, Fortis, and Woodbury Financial Services. He holds a Bachelor of Arts in history from Yale University and an MBA from the University of Pennsylvania.

Instead of only building up a portfolio of stocks and bonds to finance retirement ...

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need to leverage the ‘Transition Period’ – the five to 10 years prior to the retirement date – to secure income streams and help reduce the risk of volatility and uncertainty.

... securing an annuity at the right time can provide a more secure, steady income stream.

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THE STANDARD APPROACH Boomers and their financial professionals have traditionally relied on the 4% rule – that is, building a portfolio of stocks and bonds and then withdrawing 4% of that portfolio in retirement – as the only strategy needed for a secure retirement. This approach has been discredited recently, with a Wall Street Journal headline commenting, “Say Goodbye to the 4% Rule.” Many boomers who planned to follow this approach, and built a nest egg large enough to cover annual retirement expenses at a 4% withdrawal rate, faced an unfortunate choice after the 2008-2009 market downturn. They could either reduce their standard of living, continue to work, or increase their withdrawal rate and significantly raise the risk of running out of money. The first choice may not be feasible if many expenses, like medical costs, are non-discretionary. The second may not be available, and the third is just a bad strategy.

Another approach favored by some financial professionals is to count on steady and growing markets to help ensure that boomers have accumulated enough assets to convert to income through a single premium immediate annuity (SPIA). But this approach entails the combined risks of down markets before conversion, potentially low prevailing interest rates leading to low SPIA payouts, and inflation eroding the purchasing power of SPIA payments. An alternate approach is for boomers five to 10 years from retirement – ‘Transition Boomers’ – to leverage the Transition Period to secure income guarantees prior to their retirement. The vast majority of baby boomers still have time to prepare for retirement income before their last day at work. THE TRANSITION BOOMER CHALLENGE Transition Boomers, however, have a lot to learn. In a 2012 Allianz Life Insurance Company of North America survey of more than 1,000 Transition Boomers (aged 55-65), one-third reported being unsure of how much money will be needed to cover basic living expenses in retirement. 2 One-quarter

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appeared to be uninformed about the effects of inflation, and more than 40% may not have a realistic idea of when retirement planning should begin. Of the one-third of Transition Boomers who indicated uncertainty about their retirement income needs, 64% were age 55 to 60, and more than one-third (36%) were between 61 and 65 years old. When asked about their biggest concerns in retirement, 28% of Transition Boomers noted they feared “not being able to cover basic living expenses.” Transition Boomers significantly underestimated the impact inflation and taxes will have in retirement. Only 11% of those surveyed picked keeping up with inflation and only 6% identified taxes in retirement as a top concern. In terms of inflation, a full 25% of these pre-retirees showed unfamiliarity with inflation and the effect it can have on purchasing power in retirement. The survey also elicited disturbing responses about expected sources of income in retirement – 30% of Transition Boomers indicated they expect some retirement income from part-time work and 20% anticipate income from either an inheritance (9%) or “other sources” (11%). But a McKinsey & Company study found that 57% of retirees retired sooner than they had anticipated and 40% of them were forced into early retirement. Of that 40% of retirees, nearly half were compelled to retire due to poor health. 3 So it may be unrealistic for most boomers to assume that working longer will offset failure to plan during the Transition Period. ANNUITY GUARANTEES Perhaps the most troubling finding of the Allianz Life survey is that only 14% of Transition Boomers said they can count on guaranteed income from an annuity. These few boomers appear to be the only ones who have taken a step to secure the ‘need-to-haves’ in retirement – food, clothing, medical care and shelter – through an insured solution.

The financial media have started paying more attention to annuities as a solution to Transition Boomers’ financial problems. By locking in a guaranteed income stream through a deferred annuity in the years prior to retirement, Transition Boomers protect a portion of their assets from market declines and have an income to help cover their basic needs. This could allow the remainder of their portfolio to be held in riskier, non-guaranteed, financial products to fund the ‘nice-to-have’ aspects of retirement – such as dining out and recreation.

THE VAST MAJORITY OF BABY BOOMERS STILL HAVE TIME TO PREPARE FOR RETIREMENT INCOME BEFORE THEIR LAST DAY AT WORK. WALTER WHITE

REMOVING UNCERTAINTY In addition, by protecting a portion of their portfolio through a deferred annuity, boomers help maximize the benefit of the annuity product’s deferral period, reaping potential interest growth plus a level of protection, and not being solely dependent on prevailing interest rates at retirement to determine lifetime income. The protection, or guarantee, is backed by the issuing insurer. Transition Boomers may benefit in financial and emotional ways by making the annuity purchase decision during the critical Transition Period rather than waiting until their retirement date. By building the guarantees of a deferred annuity into their strategy – with some new annuities offering the potential for income increases while in retirement (which may come in the form of optional, additional cost riders) – Transition Boomers can take much of the fear and uncertainty out of their retirement income planning.

1 Baby Boomer s A pproach 65 – Gluml y, D’ Vera Cohn and Paul Tay lor, Pew Research Social & Demographic Trends, 2010. 2 The Allianz Life Transition Boomer s and Retirement Income Sur ve y (+/- 3% margin of error) was conduc te d by Ipsos U. S. eNation online, 6 -8 June, 2012, with 1,095 respondent s age 55 - 65, and was commis sione d by Allianz Life Insurance Company of Nor th Americ a. 3 Cracking the Consumer Retirement Code, McK insey & Company, 20 06.

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TAMING THE BULL More than just the little guy’s ‘protector in chief,’ former FDIC chairperson Sheila Bair’s views on guarantees are more varied than the label suggests.

ften called ‘she-bear’ for her protectiveness towards staff, Sheila Bair has all the qualities to make her unpopular on Wall Street: born in Independence, Kansas, a city of barely 9,500 inhabitants, she takes pride in buying most of her clothes from reasonably priced department store Macy’s – an indicator of her commonsense approach to finance. This she laid out in two children’s books on saving and, more recently, her account of the financial crisis, Bull by the Horns. STANDING UP FOR SECURITY Wall Street condescension does not deter the mother of two, but invigorates her straightforward stance on taxpayer and corporate guarantees. “Whatever guarantee is given has to be explicit, charged for and up front. If these criteria are not met, there is no guarantee, and losses have to be imposed on investors,” Bair tells PROJECT M. She justifies insurance of bank deposits of up to $250,000, her former agency’s key goal, because insured banks pay a premium and the benefits primarily go to Main Street households who do not have the time or financial acumen to analyze bank balance sheets. It also offers a stable source of funding, which banks should use to make

loans to the real economy. “Deposit insurance does not hurt market discipline and the sense of security it provides is a crucial public good.” As chairperson of the Federal Deposit Insurance Corporation (FDIC), Bair voted to at least consider the failure of Citibank, Citigroup’s insured national bank subsidiary, by placing the institution into FDIC receivership. While this approach added to her title ‘little guy’s protector in chief,’ awarded by Time magazine in 2009, the label did not always help. “The FDIC was often viewed as the little bank regulator for the $250,000 deposit accounts, unable to understand the big systemic institutions,” she says. Her suggestion on Citibank was met with derision from Hank Paulson and Tim Geithner, then in roles as US secretary of the treasury and president of the New York Federal Reserve Bank, Bair recounts. Both men preferred to spend government money on bailing Citi out. NO INSURANCE FOR BONDHOLDERS It is with implicit guarantees that Bair’s laughter, frequently interspersing the interview, dies away and her tone of voice becomes serious. “I am vehemently opposed to bailing out bondholders. When bondholders assume that the

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money they invest in a big bank enjoys an implicit government guarantee, that is classic ‘too big to fail’ and dangerously skews investment dollars. It is not accounted for in the budget, and taxpayers are not compensated for it.” Bair points to the example of former mortgage financiers Fannie Mae and Freddie Mac as a worst-case scenario. “Markets operated on the assumption that the government-sponsored enterprises’ debt was implicitly guaranteed by the government. And sure enough, the government was forced to bail their bondholders out.” The problem at the root of investment guarantees, the current nemesis of asset managers, is the low-interest-rate policy pursued by the Federal Reserve and other central banks, Bair points out. “Savers, especially those close to retirement, need a safe investment, and the government should encourage, not discourage saving. However, due to current central-bank policy, these savers are losing ground if they invest in traditional safe havens.” Consequently, they are forced to take on higher risk. “This really worries me. While 5.6% yields on junk debt may seem attractive, they are unlikely to compensate investors for the true underlying credit risk. I hope risk-averse investors will stick with safe investments, even if the returns are low, while understanding that longer-term debt is heavily exposed to interest-rate risk.” SOONER RATHER THAN LATER Still, low-interest-rate policies have to change. “Central banks should gradually let the markets normalize rates. The longer they keep rates low, the more difficult it will be for them to exit the current monetary policy.” Investors’ risk is that bonds will lose value as interest rates spike. Besides, current rates hurt lending, Bair warns.

“Demand from borrowers is low, and on the supply side, current low yields make loans unattractive.” Such accommodating monetary policy may actually lead to another crisis. “Low interest rates are designed to encourage investors to go out and take risks, which is what they did in the 2000s leading up to the 2008 meltdown.” Reflecting on the financial crisis, Bair laments a lethal mix of the notion of self-regulating markets as advocated by Robert Rubin and Alan Greenspan on one side, and Wall Street having too great a political influence on the other. “In the golden era of banking in the early 21st century, the financial services industry became too influential in Congress, with appointed officials, the academic community and, quite frankly, some of the media, too.” Regulators like the FDIC suffered from irrelevance, downsizing and staff’s diminishing morale, and in Bair’s eyes, the preferred solution too often became the bailout. COULD HAVE, SHOULD HAVE, WOULD HAVE Bair is convinced things “could have been different” – her proposed title of Bull by the Horns before she gave in to her publisher. “There were many measures the government could have taken. It could have raised bank capital requirements, imposed mortgage lending standards through the Fed and regulated over-the-counter derivatives. During the crisis, we clearly should have worked for more loan modifications.” The measures would have helped to avoid approximately one-third of the 6 million housing foreclosures initiated in 2009 and 2010, according to Bair. As a senior adviser with The Pew Charitable Trusts and leader of the Systemic Risk Council, a private-sector, volunteer group, Bair is now happy to spend more time with her family. To be tempted back into government service, “it would have to be a pretty senior job to make sense for me.” SHEILA BAIR As former chairperson of the FDIC, Sheila Bair was named one of Time magazine’s ‘100 Most Influential People’ in 2009 – largely due to her role during the financial crisis. Forbes ranked her the second-most-powerful woman in the world, behind German chancellor Angela Merkel in 2008 and 2009. In 2001 and 2002, she also sat on the board of the Pension Benefit Guarantee Corporation (PBGC).

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JOHN COTTER PROFESSOR OF FINANCE AND CHAIR IN QUANTITATIVE FINANCE, UNIVERSITY COLLEGE DUBLIN Despite the financial crisis and near-zero interest rates that are putting pension protection funds at risk and asset managers under pressure, Professor John Cotter believes guarantees can still be kept in place, provided everyone shares the burden.

T H EN

IF defined benefit (DB) plans could provide similar income streams at the same or even less cost than a defined contribution (DC) plan, as some experts maintain, why is the shift to DC plans increasing?

THEN it’s because in a DB scheme, the company would have to shoulder the majority of risk – and they don’t see the benefits in that.

IF the shift from DB to DC pension plans continues, what is your biggest concern?

THEN my biggest concern is that, in opting for a DC plan, the risk is going to be carried by someone who is ill-prepared to deal with the decision-making and the risks involved.

IF guarantees cannot be fulfilled under the current low-interest-rate environment, what do you expect to happen?

THEN more political pressure will be put on policymakers to keep guarantees in place. Even if they are not functioning well, the same political pressure that called those guarantees into being will also cry out to have them saved.

IF neither individuals nor companies are prepared to shoulder inflation, investment and longevity risk, what’s the alternative?

THEN the onus should be shared by both parties. By requiring companies to institute auto-enrollment, they are not put at a competitive disadvantage to a company that doesn’t offer auto-enrollment. Autoenrollment also puts an onus on the individual, who is now signed up and committed to the fund.

IF we were offered the chance to design a new pension framework from scratch, do you think we would get rid of pension protection funds altogether?

THEN the people who created them would either continue to keep them in place or put themselves at political risk. I think it is unlikely that these schemes will be eliminated altogether.

IF a pension protection fund runs into trouble, do you expect it to be bailed out?

THEN – assuming there is a state to bail them out at all – yes, I believe there will be enough political pressure to rescue it.

To listen to the interview with professor John Cotter, please visit PROJECT M online: projectm-online.com/global-agenda/if-then-john-cotter

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Big investments: investors are showing a greater interest in infrastructure projects

LOOK TO THE SILVER LININGS As risk-free return has become return-free risk, investors are now eyeing corporate investments for relief. Itâ&#x20AC;&#x2122;s a reasonable risk tradeoff â&#x20AC;&#x201C; for better returns.

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ven the dark clouds of the current low-yield environment have a silver lining. “Equities in particular, with a potential of up to 6% return, are the alternative to government bonds. But because of their long-term horizon average, holding periods of equity investors must increase from the current six to 12 months,” says Ingo Mainert, chief investment officer balanced Europe at Allianz Global Investors. This could reduce risk and increase returns, Mainert adds. Similarly, the US Financial Crisis Inquiry Commission identified banks’ overreliance on short-term debt as a main reason for the 2008 crash. Battered by the after-effects of the crisis – financial repression and low interest rate policies – investors are struggling to escape the low-yield environment whose main burden is borne by savers and retirees. High-saving countries are particularly exposed. “With interest rates on 10-year government bonds in Germany hovering at 1.5% and inflation around 2%, a retirement nest egg of €100,000 ($130,000) today will melt down to €95,111 ($123,644) over 10 years. That’s nearly a 5% loss in purchasing power before even considering taxes,” Mainert warns. Not even government bonds, formerly known as safe havens, can halt this trend. The world’s largest asset class is infected with low interest rates. What used to be a risk-free return has morphed into a return-free risk. “To achieve their return targets, asset managers and investors have to substantially increase their risks,” Mainert warns. A GROWING APPETITE FOR RISK Such a macroeconomic framework requires a diversified portfolio. Investors are forced to allocate a greater share to risky assets like equities, corporate bonds, investments in emerging markets and alternative investments such as real estate, commodities and infrastructure. “Institutional investors, especially insurers and to a lesser degree pension funds, show an increasing appetite for infrastructure investments,” says Mainert. Stabilizing not only investors’ returns, infrastructure investments by pension funds could also spur economic growth, according to a recent report by the Organization for Economic Co-operation and Development (OECD). “The financial crisis has aggravated the infrastructure gap further, reducing the scope for public investment, while at the same time affecting traditional sources of private capital. Institutional investors such as pension funds may as a result play a more active role in bridging the infrastructure gap,” the report states. The OECD estimates the gap to be $53 trillion worldwide. In other words: 2.5% of an annual global gross domestic product (GDP) would be needed to meet demand until 2030.

At the same time, “The way infrastructure models like Public Private Partnerships (PPP) are being financed changes dramatically,” says James Stewart, chairman of Global Infrastructure with consulting agency KPMG. As regulators require banks to reduce their risk exposure, Stewart expects financial institutions to leave their traditional tasks of financing long-term projects and pass the baton on to governments, municipalities and institutional investors. “Total financing from the banking system for infrastructure projects around the globe fell to $382.3 billion in 2012, a 6% decrease from the $406.5 billion recorded in 2011,” says Raffaele Della Croce from the OECD’s Directorate for Financial and Enterprise Affairs. Still, less than 1% of OECD pension fund assets are allocated directly to infrastructure projects, leaving huge potential. Pensions funds such as Ontario Municipal Employees Retirement System (OMERS) could be taking their place. With $55 billion of assets under the management of one of the biggest pension funds in Canada, OMERS has allocated 15% of its total portfolio to infrastructure. ACCESSING INFRASTRUCTURE Infrastructure debt financing offers a reasonable trade-off between risk and returns in terms of fixed income assets. The main issue for infrastructure projects in Asia is execution risk, Karen Chan, senior research analyst with Allianz Global Investors in Hong Kong, told the Allianz Knowledge Site. Even if you are awarded the project, you may not get the land because people living there object, so the government cannot give it to you to develop.” Institutions are struggling with development and construction. One way to mitigate legal and financing risk is to deliver via regulated utilities, Stewart says, pointing to investments of £80 billion ($119 billion) by water companies in the UK over the last 20 years. “The strength of the regulated market is a resetting of the price and efficiency targets every five years by independent regulators.” However, “taking that construction risk not only means investors can get a higher yield for the whole life of the transaction but also enables them to have a greater impact on the financing structure and the monitoring control rights over the life of the transaction,” Deborah Zurkow, head of Allianz Global Investors’ Infrastructure Debt team, points out. Apart from that, additional protections such as construction bonds and liquidated damages are available. In any event, the long-term investment horizon of infrastructure gives some hope to investors and savers. “If outright monetary policy measures from central banks were to disappear, interest rates could rise again,” Mainert concludes.

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THE DEMOGRAPHER’S NEW MICROSCOPE A new approach to predicting life expectancy could also help to price guarantees on retirement income streams, says David Blake.

hen British mathematician and actuary Benjamin Gompertz presented his law of human mortality in 1825, his basic assumption was simply that a person becomes more likely to die while growing older. This may have rung true to Gompertz, then a 46-year-old man already five years beyond the average life expectancy of his time. However, his simple linear equation neglected to factor in one of the important age-period effects of his time. Throughout the 19th century, infant and maternal mortality were strikingly high and, of those children who survived childbirth, almost half died before the age of five. Though many contributions in the field of mortality law were made throughout the latter half of the 19th century, actuarial mortality modeling is a relatively new science. Largely forgotten over much of the 20th century, it became an existential question towards the end of the 1990s, when – at about the same time the dot-com bubble burst – actuaries discovered that the pensionable population was significantly outliving their models’ predictions. FIXING FAULTS Given that liabilities increase by 3% for every year a 65-year-old pensioner outlives the modeled life expectancy, the impact of lower mortality rates at higher ages was significant, with companies opting out of pension provisioning to rid themselves of legacy liabilities. “When put to the test of real-life events, existing mortality models often proved faulty, and demographers amended them with ad hoc fixes as they went along. To avoid this

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happening in the future, we offer a new approach for designing a mortality model from scratch,” David Blake, professor of economics at the Cass Business School in London, tells PROJECT M. Together with PhD candidate Andrew Hunt, he developed a ‘general procedure’ (GP) for constructing mortality models. Moving away from current one-size-fits-all mortality modeling, Blake and Hunt’s new approach uses a “combination of statistical methods and expert judgment to identify sequentially every significant demographic feature in the data and give it a specific functional form. “The GP follows individuals through time as they age. This is crucial because, as we know, life expectancy depends on year of birth,” Blake points out. “Our point was not to introduce yet another new model, but to suggest a standardized approach that could become the basis for building all countryspecific models in the future.” ACCOUNTING FOR NATIONAL DIFFERENCES Current models attempt to forecast mortality by imposing a fixed structure across three key features known to influence mortality: age, period and cohort (or year of birth). The GP begins by identifying all the significant ageperiod terms according to each country’s unique attributes. In Western countries, for instance, the mortality rate in the first six months is high and then falls off only to rise again during the teenage years when reckless behavior – particularly among males – causes the mortality rate to increase. Once this ‘accident hump’ has been crossed, the mortality rate falls again until – at

THIS IS CRUCIAL, SINCE WE ARE CURRENTLY TALKING ABOUT THE WRONG TYPE OF GUARANTEES. DAVID BLAKE

Marlene Dietrich in Morocco: one cohort effect, says Blake, is the increasing number of women adopting more â&#x20AC;&#x2DC;maleâ&#x20AC;&#x2122; lifestyle habits.

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around 45 – it begins its slow, fairly linear climb. The significance of the GP is its acknowledgement of national differences. Where seven age-period terms may be identified for one country, in another it might be six; the weighting of each of the terms might also be different. For instance, when Blake and Hunt applied the GP to UK data, they identified seven ageperiod terms: the general level of mortality (modeled as a constant); increasing mortality with age (modeled as an upward sloping straight line); young adult mortality, which is a humped-shaped function centered at age 25; childhood mortality (a put option); postponement of middle-age mortality to oldage mortality (a Rayleigh function); peak of the accident hump around ages 18-19 (a lognormal function); and middle-age deaths between ages 55-65 (a normal function). IDENTIFYING COHORT EFFECTS In comparing these results with those of the United States, they found that although the first three age-period effects were the same as those of the United Kingdom, they did not have the same relative significance. Once all the age-period terms have been identified, any significant structure remaining in the data can be associated with the cohort effect. One of the key discoveries from implementing the GP was the risk of wrongly allocating an age-period effect to a cohort effect. Since a cohort effect “follows” each cohort as it ages, whereas an age-period effect does not, then such a misallocation leads to increasingly poor mortality-rate projections over time. When Blake and Hunt expanded their modeling approach to countries outside the United Kingdom, their results indicated that some countries didn’t have a strong cohort effect. The GP picked this up, whereas a standard age-period-cohort model applied to these countries might well estimate a statistically significant cohort effect, although the relationship would be spurious since what was being picked up was in reality another age-period effect.

For instance, whereas obesity – which has almost doubled in the United States since the early 1960s – has a cohort effect there, as described by US demographer S. Jay Olshansky, it doesn’t in Japan. “The strongest cohort effect historically recorded was triggered by the so-called Spanish flu epidemic at the end of World War I. This is still visible in datasets today. Babies that survived the pandemic were much stronger and have had noticeably lighter mortality every year since, compared with neighboring birth cohorts.” Blake also points to increasing numbers of women picking up the bad habits of men – smoking and drinking – as another cohort effect. PRICING GUARANTEES According to Blake, a mortality model generated by the GP will accurately describe features observed in the past and be easy to calibrate and explain to other stakeholders. It will also capture specific mortality features for different birth years and project them as individuals age, and provide reliable forecasts of mortality rates at specific ages for longevity risk management strategies using, say, longevity swaps. * “We believe the general procedure will help demographers to look out for certain features in a dataset, whilst recognizing that these features might occur at different times in different countries, or not at all.” Apart from a more effective looking glass for demographers, Blake believes the GP will also be helpful in pricing guarantees on retirement income streams more accurately. “This is crucial, since we are currently talking about the wrong type of guarantees. “Instead of accumulation-phase guarantees (such as guaranteed minimum returns), we should focus on trying to guarantee income during the decumulation phase. Since these guarantees are very far in the future, a good mortality forecasting model, specifically designed for the population of interest, is critical to the commercial success of those providing these guarantees.”

*Hunt, A ndrew, and Dav id Blake, Febr uar y 2013: A General Procedure f or Constr uc ting Mor talit y Models, Discus sion Paper PI -1301, Pensions Institute (pensions-institute.org/work ingpaper s/w p1301.pdf )

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BREEDING RESILIENCE The most prominent cohort effect in datasets across the world was triggered by what became known as the Spanish flu. Ravaging populations in countries around the world from 1918 to 1920, reports on this unusually deadly influenza epidemic were not censored in Spain, creating the false illusion that the country was particularly hard hit. Worldwide, 50 million to 100 million people died. Those who survived had significantly higher life expectancy than those born a few years earlier or a few years later.

FURTHER READING Read more about the potential effects of lifestyle on mortality rates in PROJECT M #14 (‘A matter of lifestyle’) or online: projectm-online.com/ new-perspectives/ a-matter-of-lifestyle

Gordon Clark believes an element of risk and uncertainty could soon be found behind what was once a hard and fast guarantee.

A PROMISE FORMERLY KNOWN AS A GUARANTEE While the term ‘guarantee’ is likely to stay, the underlying contract may well be far less binding than savers are used to.

uarantees are treasured by many private investors, but their time may be over. “Unless asset managers ignore the current low-yield environment as an historical aberration, we will soon see risksharing in what was formerly known as a hard and fast guarantee,” predicts a University of Oxford economist and geographer, Professor Gordon L. Clark. “It makes no sense to offer a guarantee providers can’t stand behind. Consequently, everything but lower assumed rates of return seems foolish to me.”

CHANGING EXPECTATIONS This may come as a shock to savers as defined contribution (DC) schemes place more and more risk on their shoulders. Consequently, Germany’s Riester Rente supplementary state pension at least guarantees contributions. In Belgium, Slovenia and Switzerland, plans must provide a predefined annual minimum return, while Chilean and Danish pensions must meet a relative return guarantee. They cater to investors’ loss aversion, which seems to be a fundamental human trait.

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stages of a professional career, disposable income is often constrained by mortgage payments. “As this is often considered part of retirement saving, younger workers are disinclined or simply unable to save additionally in an investment or retirement product. Given their limited professional experience, younger people also have greater difficulty in conceptualizing the income they may require in old age.”

“Riester pension plan participants in Germany demonstrated a systemic shift away from risk between 2000 and 2010. Savers in Anglo-Saxon countries did not show the same level of systematic loss aversion over the same period of time.” Clark’s book (with colleagues), Saving for Retirement (Oxford University Press, 2012), provides a comprehensive treatment of the topic for the United Kingdom. In part, the reason for a greater interest in equity products reflects the confidence of UK residents in the upward stock market trajectory (since 1986).

IT’S NO GOOD HAVING FINANCIAL INSTITUTIONS GO TO THE WALL AS THEY TRY TO PAY OUT ON AN ABSOLUTE BASIS. GORDON L. CLARK

On a more granular level, the use of guarantees largely depends on the saver’s age. “Younger people are more willing to trade away a guarantee for a higher long-term average rate of return over their working life,” says Clark. “The need for guarantees starts to make a substantial difference to savers’ choice of products at age 45 to 55, depending on their expected age of retirement.” Clark provides three explanations for the change in savers’ perceptions. In the early

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GUARANTEES: A MATTER OF EXPERIENCE “Older, high-income workers in the City of London have a wider range of savings instruments and more experience in judging a good-quality investment product than their younger counterparts. And they often join together risky and less risky products to achieve a degree of protection while allowing for significant upside potential.” However, the advantages of guarantees are less clear than often thought. Not only can they entail hefty fees, but they may also lower a savings plan’s upside potential. While they bring the greatest value to savers when markets become turbulent, as the risklab study Assessing the Nature of Investment Guarantees in Defined Contribution Pension Plans shows, this is also when their costs rise. “Guarantees are particularly expensive in times of greater market volatility and uncertainty,” Clark says. He suggests an alternative. “It is sensible to think of guarantees not as strict contractual agreements. Rather, changing conditions should be taken into account and future guarantees would allow for rolling variations of the guaranteed return.” With returns contingent on market circumstances, the promise would be renegotiated every three to five years and possibly adjusted. What sounds like a provocative attack on consumer protection comes from an academic who carefully weighs his words before speaking. “This is an unpleasant truth,” Clark admits. “But it’s no good having financial institutions go to the wall as they try to pay out on an absolute basis.” In other, less balanced words: today’s savers have to face the reality of lower and more volatile retirement incomes.

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“I wouldn’t say the future is bleak, but it is certainly darker than a decade ago,” Clark continues. Demographic change and reduced economic growth rates squeeze benefits paid and revenue received. “Governments will likely be unable to provide a high level of income replacement through social security as they did through the 1980s and ’90s. Secondpillar DC schemes, designed to supplement state pensions, are unlikely to compensate for the cutbacks and are hardly fair in the sense that those who bear most of the risk are least prepared to do so.” WHAT CAN BE DONE? Clark suggests a NEST-type occupational pension scheme, compulsory for the majority of workers. “NEST attempts to provide some certainty by controlling the downside risk and ensuring that people get a real rate of return for their contributions. If you are unable to cope with full market volatility, you will have

to accept a much lower rate of return, which will not be particularly lucrative for low- or middle-income earners.”

I WOULDN’T SAY THAT THE FUTURE IS BLEAK, BUT IT IS CERTAINLY DARKER THAN A DECADE AGO. GORDON L. CLARK

The outlook is slightly rosier for high-income earners if they diversify their savings instruments according to their income aspirations for retirement. “Our research shows that highly motivated people about the right age with the right income are very astute savers. And they don’t have all their eggs in one basket. It is lower-income earners who have concentrated portfolios and are most exposed to the performance of one type of pension as opposed to other types of pension.”

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INTO THIN AIR With the demise of the risk-free rate, regulators are pursuing a dangerous path towards unfounded benchmarks.

n pre-crisis times, defining the risk-free interest rate might have been a question for an undergraduate economics class. Today, even long-standing asset managers lose sleep over it. Critically important to assess the value of guarantees and future liabilities such as cash flows promised to annuitants, the risk-free interest rate â&#x20AC;&#x201C; more precisely, a duration dependent risk-free rate curve â&#x20AC;&#x201C; is a major element of European risk-based regulation such as Solvency II or the

Institutions for Occupational Retirement Provision (IORP) directive. In the undergraduate class, the correct answer would have been the government yield curve or a swap-based index. Yet, times have changed, and regulators and academics alike have difficulties identifying a risk-free rate in the markets. The issue becomes even more burning in the current low-yield environment: regardless of what benchmark is used, the number will be relatively low, even

The Netherlands: adding regulated traction to a slippery economic reality

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REGULATORS KNOW BETTER DNB introduced a risk-based framework for pension plans based on the euro swap rate (see graph) as early as 2007. At the time, pension funds’ funding levels were around 140%. In the wake of the financial crisis, the average funding ratio fell below the threshold of 105%, leading to the introduction of short-term recovery plans. Asset values recovered quickly, but due to a lower term structure and rising liabilities, funding ratios remained below the minimum requirement. With the recovery plans due to expire at the end of 2013, eventually leading to cuts for current retirees, the DNB rushed in and introduced the ‘September Pensions Package,’ including, among other measures, the UFR as a ‘real,’ long-term, risk-free interest rate. The UFR starts at a maturity of 20 years and is extrapolated over a 40-year horizon to a level of 4.2%, leading to a divergence between the observable market rates at 2.5% and the discount rate that Dutch pension funds use to value their liabilities. Critics suggest the UFR disguises economic reality. Regulators justify the new benchmark by pointing to a lack of a liquid and deep market for rates beyond a 20-year horizon. The long-term expectation of inflation and the short-term interest rate are assumed to be at 2% and 2.2%, respectively. This follows the Solvency II regulation for insurers, but other than that, the long-term interest rate is a rather arbitrary benchmark. Observable market rates with a maturity longer than 20 years are available, and neither the historical average inflation rates (3%) nor the average Dutch real interest rate (1%) support the value of the UFR. The UFR constitutes a significant shift in the regulatory

I N C R E A S I N G D I S C O U N T R AT E The graph shows the difference between the DNB’s interbank swap rate as of 31 August 2012 (yellow line), used as the risk free benchmark, and the bank’s UFR as of 30 September 2012 (red line), demonstrating an increase of the discount rate at the long end. 4.0

Discount rates as of September 2012 Discount rates as of August 2012

3.5 3.0 Discount rate

at the long end of the curve. A low discount factor will lead to a high present value of future liabilities, raising solvency and funding requirements for insurers and pension funds. Measures to relieve the pension industry of the immediate pressure of rising liabilities and mitigate the threat of cutting benefits are under way both in Europe and the US. Germany debated legislation reneging on insurers’ binding promise to share hidden reserves with their clients in late January. The US Congress passed a relaxation of the corporate pension discount rate formula in June 2012. Within the current Solvency II approach, regulators propose to alleviate funding requirements by directing the discount factor for future liabilities – that is, the risk-free rate – towards the long end of the curve. The so-called Ultimate Forward Rate (UFR) was introduced for pension funds by the Dutch regulator De Nederlandsche Bank (DNB) in September 2012.

2.5 2.0 1.5 1.0 0.5 0.0 1

7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58 Maturity in years

Source: De Ne der landsche Bank

paradigm: with it, the Netherlands moved from a marketconsistent, risk-based approach into the thin air of a framework engineered by regulators. This will have major implications for pension providers and future retirees. Changes in the regulatory framework do not affect a fund’s capability to meet liabilities towards future retirees. While Dutch pension funds may improve their disclosed funding levels and thus obviate curtailments simply by changing the scale on their measure of liabilities, the financial position of the fund remains unchanged. KICKING THE CAN DOWN THE ROAD Due to the UFR, pensions of younger generations are valued differently from those of older generations. If the current low-yield environment prevails, the cuts are simply postponed and risk is shifted to the young. Prior to 2007, Dutch pension funds used a fixed actuarial discount rate, set at 4%, to value their liabilities. Both the fixed actuarial discount rate and the UFR have a side effect of reducing funding ratios’ volatility leading to seemingly more predictable contributions and benefits. But where the 4% actuarial discount rate erred on the side of caution when interest rates were still high, the UFR disguises the economic reality (see graph). Under the UFR regime, movements at the long end of the yield curve do not affect the valuation of the liabilities and the funding level. While the risk is invisible in the pension fund’s funding levels, it still exists. This runs counter to the notion of a risk-based framework, as real economic risk is not reflected in the balance sheet.

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FOCUS J UA N I TA R A M A N Having faced childhood poverty, divorce and single motherhood, the 74-year-old mother of four is now enjoying a comfortable retirement.

THE YOUNGER WIFE’S CURSE New research has shown that many typical life choices leave women financially much worse off than men in retirement. Women around the world discuss their current and future financial outlook.

» I WAS RUNNING

SCARED WHEN I WAS YOUNGER. I THOUGHT IT WOULD BE WORSE THAN IT IS. JUANITA RAMAN

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uanita Raman, 74, struggled financially for most of her life. As a child, she lived hand-to-mouth with a father who was an alcoholic. Raman then put herself through college. Later, after she was divorced, the single mother of four worked very hard to provide for her children. Now, Raman is sitting pretty, with a paidfor home in Chicago and an adequate income from Social Security and an IRA. She travels occasionally and enjoys life with her grandchildren. But getting there was a journey

plagued with worry: “I was running scared when I was younger. I thought it would be much worse than it is,” she said. Raman, who worked as an editor, started saving late for retirement, but then did so diligently, avoiding debt. Later, she sped up installments on her condo to get it paid off. Clearly, she is among a set of women who can consider themselves fortunate. Many women are not so fortunate. A new study by Allianz shows that a disproportionate number of women – especially those who have

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been widowed – are confronted with old-age poverty. The odds are stacked against them, given a woman’s longer life expectancy than a man’s, and her comparatively lower retirement savings, after breaks from working to care for children or elderly relatives. Yet, governments are cutting back on support, shifting the responsibility for retirement to individuals. This means women of all ages must be aware of demographic and other trends that may strongly impact their financial future; they may need to put extra time and effort into developing an informed investment strategy and saving to ensure they are financially secure in retirement.

SEEKING SELF-SUFFICIENCY Stella Lobefaro is 29 and she is already considering these types of long-term challenges. Hailing from southern Italy, she and her newlywed husband moved to Munich in search of good jobs and a bright future for the children they want to have. The couple started saving even before they were married and plan to buy an apartment as a pillar of their investment strategy, along with a cashvalue life insurance policy. Lobefaro says she has a high need for financial security. “Maybe it’s because the situation in my country is among the worst, but I don’t intend to rely on the government for retirement. I want to be able to support

I DON’T INTEND TO RELY ON THE GOVERNMENT FOR RETIREMENT. I WANT TO BE ABLE TO SUPPORT MYSELF. STELLA LOBEFARO

S T E LL A LO B E FA RO The 29-year-old newlywed communications professional is facing the future costs of child rearing and home ownership.

VO R N A M E N A M E Seosam quat hici quunt laut volupti testium venecae. Feruntiorate cus et et magnit endesequi vendeli gendell ignime sus et utem sunt pada. Seosam quat hici quunt laut volupti testium venecae. Feruntiorate cus et et magnit endesequi vendeli gendell ignime sus et utem sunt pada. Seosam quat hici quunt laut volupti testium venecae. Feruntiorate cus et et sun.

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Picture Galler y Bonus content in the PROJECT M app

FOCUS

» HAVING A BABY

MAKES SAVING MORE IMPORTANT. AND IT’S EASIER TO MAKE THE SACRIFICE OF SAYING, ‘NO.’ RENEE MARINA

myself,” she says. Lobefaro dreams of having enough money to visit her parents more frequently in southern Italy and enjoying a retirement filled with travel to faraway places, like Nepal or India. However, there’s a long road and many question marks ahead. What will happen if she wants to take a break from her job in communications after the kids are born? And how much will it cost to send her children to a bilingual school? A NEW PERSPECTIVE FROM PARENTHOOD Renee Marina recently crossed some of these life thresholds and is taking stock of the answers she has found for herself. Now in her early 30s, the insurance company employee lives in Malaysia and has a daughter who is

RENEE MARINA The 30-something mother of one from Malaysia is learning how parenthood can change your outlook on spending and saving for retirement.

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almost two years old. Marina used to think 30 seemed so far away: “I was so optimistic. I thought I’d be well-off by the time I was 30.” Today, she realizes how expensive it is to maintain a good lifestyle and provide for a child; and as Marina does this, she understands that every dime spent is a dime not saved for retirement. “After having a baby, I started thinking more about her than me. Would she have enough if something happened to me? This makes saving more important, and it’s easier to make the sacrifice of saying, ‘no,’” Marina said. Marina and her husband are working to pay off their home and each puts away money on a monthly basis toward a retirement they hope will be full of travel and grandkids.

MARIA ELISA AO K I M O N TA N A R I The 48-year-old mother of a teenage girl is facing the challenge of imparting financial wisdom to the next generation.

LEARNING FROM EXPERIENCE Maria Elisa Aoki Montanari of Brazil has a similar dream of a comfortable retirement. She has saved up a tidy nest egg after living through her country’s hyperinflation and seeing the currency change five times during her lifetime – from the cruzado, to the cruzado novo, the cruzeiro, the cruzeiro novo and the real. “I don’t feel comfortable if I don’t have savings,” explained Aoki Montanari. “I grew up in a crazy economy in an unstable situation. The inflation was so bad that when we received money, we went right to the shop to spend it because the next day the price could be higher.” Brazil’s fragile situation shaped Aoki Montanari’s money experience, along with the lessons her father taught her as a girl: build up an emergency fund by controlling expenses and never expect the government to provide for your retirement. Right now things look good for Aoki Montanari, who is 48 and works

as a manager in the car department of an insurance company. With her private savings plan, a company pension plan, a life insurance policy and cash savings, Aoki Montanari is on target to meet her retirement goals. She plans to stop working at 60 and then return to university, volunteer and soak up the rich cultural offerings available in the city of Sao Paolo, where she and her husband own their own apartment. One thing is proving harder than Aoki Montanari had imagined: imparting to the younger generation the importance of saving. Her daughter, like any typical 14-year-old, is interested in the latest fashions and gadgets. “The difficult part today is teaching children that you always have to save in life because of the troubles that may come along. You may get sick or have some kind of an emergency. I tell my daughter that she has to know what a real emergency is,” said Aoki Montanari. “I wouldn’t call it an emergency if you don’t have an iPhone.”

I DON’T FEEL COMFORTABLE IF I DON’T HAVE SAVINGS. I GREW UP IN A CRAZY ECONOMY IN AN UNSTABLE SITUATION. MARIA ELISA AOKI MONTANARI

FURTHER READING Read the Allianz report The Younger Wife’s Curse: projectm-online.com/ research

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Loc al k nowle dge

CHALLENGING AND SELF-RELIANT The 50+ generation in Europe feels well-informed about financial matters. According to a recent survey, its members mostly make retirement decisions for themselves with only a little specialized advice from financial experts.

he 50+ generation, considered ‘the wealthiest generation ever,’ is approaching and entering retirement in the next 10 to 15 years. Collectively, they have an enormous amount of accumulated assets. As retirement nears, many of them are seeking a strategy for financing their golden years by optimizing investment earnings and restructuring assets. The task is significant. They have to decide how they can decumulate assets after entering retirement. They also need to generate an income stream that provides them with an adequate overall retirement income. And they have to do both by making financial decisions that will have profound consequences on their retired life. The structure of retirement income for all individuals has begun to change as a result of pension reforms in western Europe, and individuals now need to take more responsibility for their retirement income. Wealthy retirees and soon-to-be retirees can share their experiences with retirement planning; yet the actual need for detailed planning depends on the existing pension system within a country and the initiated reforms. A study conducted by Allianz Asset Management in cooperation with market research firm TNS surveyed the

retirement approach of wealthier people aged 50-70. Seven European countries were examined: Austria, France, Germany, Italy, the Netherlands, Switzerland and the United Kingdom. The study, Preparing for Retirement – Financial strategies of the aff luent 50+ generation in European countries, focused on the wealthy, who have already been confronted with low replacement rates of public pensions compared with their current income and living standards. As a result, they have taken additional steps to reach a retirement income that allows them to maintain their living standard. This group is likely to have more experience and ability to master retirement strategy and investment decisions. Nevertheless, decisions about retirement finance are particularly difficult with respect to both the time horizon and complexity: people have to know how financial markets and inflation will develop in the future. With respect to inflation, the results underline the uncertainty. AUSTRIANS LEAST CONCERNED ABOUT INFLATION In all countries except Austria the majority of respondents (56%) expressed that inflation is the main financial risk in retirement. In Germany and the United Kingdom, this group

MAIN FINANCIAL RISKS IN THE RETIREMENT PHASE Inflation is the main perceived financial risk across all countries, particularly UK and Germany Figures in %

Total

Austria

France

Germany

Italy

Netherlands

Switzerland

Inflation eats up my savings

Unforeseen expenses, especially medical expenses

Capital markets perform badly

I could outlive my assets

Source: Preparing f or Retirement – Financial strategies of the af f luent 50 + generation in European countries, Allianz Inter national Pensions

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is even larger – 60% and 65% respectively. Uncertainty also surrounds unforeseen expenses, particularly in Austria. Only a small number are afraid of outliving their assets. The last decade has shown the difficulties in assessing the various investment risks on financial markets. With pension reform processes also forcing people to adapt, it is not surprising that most European respondents are uncertain if they can maintain their living standard. Only the Swiss and Dutch respondents are optimistic, as they can build on a broad mandatory pension system. Indeed, the majority of Swiss interviewees (81%) are very satisfied with their retirement planning, with only a minority admitting to mistakes. The least satisfied are the French and Italians (46% and 54% respectively). Sharp pension cuts in Italy and pending reforms in France have led to increased uncertainty. While the French are not certain they made mistakes, 27% of Italians believe they made errors. TOO LITTLE OR TOO LATE The main mistakes people in all countries think they made is having saved too late or invested too riskily. Having chosen the wrong products tops the error list in Austria, while Britons mostly believe they have not saved enough. In all countries, retirement planning and saving is not clearly assessed by retirement products. In fact, people hold only a small amount (on average 30%) of their assets in retirement accounts. However, although savings and investments are not in retirement accounts, many people want to use them for retirement preparation. With the exception of Italy, where only 30% of assets (not in retirement accounts) are used for retirement, 40-50% of assets are earmarked for retirement in the other countries surveyed. This reveals that retirement and investment decisions are closely interlinked. The main challenge for product providers is this broad assessment and the

Across Europe, inflation was recognized as the main threat to retirement wealth.

demands wealthier (retirement) investors require in products: good performance and comprehensibility. When planning for retirement, 42% of the Dutch and 48% of Britons rely on themselves. They prefer to make decisions without assistance. Respondents in other countries use financial experts only for specialized needs. This attitude puts most of them at a distance to financial services providers. The fact that this group largely feels well-informed and uses a wide range of information sources (with Internet searches ranking high on the list) further underlines their demanding, self-reliant character.

F U R T H E R I N F O R M AT I O N Allianz, Preparing for Retirement – Financial strategies of the affluent 50+ generation in European countries, International Pension Papers, 2013 Allianz Demographic Pulse, It’s time to rethink retirement, No. 9 2013 Both available online at: projectm-online.com/research

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THE QUEST FOR ETERNAL YOUTH We may not covet its beauty, but can we gain from the naked mole-rat’s exceptionally long and healthy life?

he naked mole-rat looks like a lumpy pork sausage with the head of a walrus. Its wrinkled, papery skin bunches around a shapeless body, while its most startling feature is a set of saber-like teeth. It’s hard to imagine anyone finding it cute. But Rochelle Buffenstein does. The Zimbabwe-born professor of physiology has 2,500 of the rodents in the Naked Mole-Rat Center she heads at the University of Texas Health Science Center in San Antonio. “I don’t find them ugly,” she laughs. When the German naturalist Eduard Rüppell first introduced the creature to science in 1842, he thought its

lack of hair and long teeth were a sign of disease. Now we know that it may not be a beauty, but it is blessed with a long and practically disease-free life. Buffenstein calls the naked mole-rat the ‘Holy Grail’ of longevity research, one that defies traditional old-age theories, which make us naively believe we have the answers. Aging is, however, one of the least-understood biological phenomena. The biologist was the first to realize rodents made ideal age-research models when, in 2002, one of hers died at 28, breaking the longevity record for rodents in captivity.

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Nine years later, Ruffenstein’s lab produced a real Methuselah. A naked mole-rat is the size of a mouse and based on that size, should live about eight years. ‘Old Man,’ as he was fondly named, lived just over 30 years. He nearly didn’t, though: at 23, his muscles shrank and he became a walking skeleton. “The vet advised us to put him down,” recalls Buffenstein. “But every time we wanted to, we found him mating or eating and enjoying life.” Old Man sired his last litter shortly before dying, highlighting another characteristic that makes the naked mole-rat interesting: its compressed morbidity, or shortened old age. It starts to age at about 24 years, the equivalent of 85-90 human years. Until then, it acts like a young animal and shows no loss of metabolic rate, bone mineral density, muscle mass, body fat or cardiac health. Even when old age sets in, it remains active and mentally fit.

» THE MORE IMPORTANT QUESTION IS NOT HOW

TO MAKE PEOPLE LIVE 200 YEARS, BUT HOW TO GIVE THEM A HEALTHY 100 YEARS. ROCHELLE BUFFENSTEIN

Humans, in contrast, start the slippery downhill slope at 30 for women and 35 for men. The older we get, the greater the risk of chronic disease and, worse, dementia. So it is not surprising that the media initially sensationalized news of the magical rodent, claiming it could help us live to 200. Buffenstein, however, is not chasing the elixir of life: “The more important question is not how to make people live 200 years, but how to give them a healthy 100 years.” She believes humans have long outlived their sell-by date. The world’s oldest recorded person was the French Jeanne Calment, who died aged 122 in 1997. “I don’t think we’re able to extend lives more than this,” she adds, pointing out that, based on body size, the maximum life span for a healthy 70 kg male should be 35 years. SUPERHUMAN QUALITIES Buffenstein’s research shows that to cope with their extraordinary living conditions, naked mole-rats have evolved superhuman qualities. They don’t feel pain due to acidic chemicals, don’t get cancer, can survive long periods without oxygen and their DNA most likely has extraordinary self-repairing mechanisms. They also defy the popular free- radical theory of age, showing up to eight times more oxidative damage in their cells than mice, with no ill effect. In their natural habitat in arid and semi-arid regions on the Horn of Africa, the creatures live in colonies of up to 300 in underground chambers, which they never leave. Their

highly organized social structure, where workers serve a breeding queen, is rare among mammals, and its socially secure environment is thought to contribute to the evolution of longevity mechanisms. In the overcrowded chambers, however, oxygen levels are low and carbon dioxide is high. Yet, the rodents can survive periods of oxygen deprivation of up to 30 minutes that would cause brain damage or death in other mammals. We now know they manage this by retaining fetal brain characteristics that protect unborn mammals in the low oxygen environment in utero. They also lack certain pain neurotransmitters, so do not suffer from stinging acids released by high carbon dioxide levels mixing with water to form carbonic acid. When these mechanisms are understood, they could provide therapies for chronic pain, strokes and other age-related diseases. FIGHTING CANCER Perhaps most exciting, though, is the rodent’s resistance to cancer. If oncogenes, genes with the potential to cause cancer, are injected into human or mice cells, they form aggressive, cancer-forming cells. Research now shows that the naked mole-rat’s cells quickly respond to oncogene transformation by stopping the affected cell from dividing. Its tissues appear to be able to recognize abnormal cells, neutralize their cell-dividing properties and repair the DNA. If that fails, the cells are programmed to die. Similarly, if the rodents are exposed to toxins, their cells stop dividing until conditions improve. It is this excellent ‘quality control,’ a system of checks and balances to make sure DNA is translated into the highest quality of proteins with no mutations, that fascinates Buffenstein. “The critical thing is to work out how the animals maintain that pristine genome, proteome and transcriptome. We now know the rodents have raised levels of both DNA repair enzymes and raised protein degradation pathways. But the puzzle is to work out what is regulating this at a higher level than humans are able to achieve.” But research is still in its early stages. “We’re still doing the basic stuff that people have been doing on mice for 100 years, but we are catching up quickly.” When they do, perhaps people will stop calling the naked mole-rat a ‘saber-toothed sausage’ and see it for the beauty it is.

F U R T H E R I N F O R M AT I O N To see an image gallery of other oddly long-lived animals, visit PROJECT M online: projectm-online.com/new-perspectives/ the-quest-for-eternal-youth

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TO BENEFIT OR NOT TO BENEFIT While immigration as a solution to demographic change is controversial in many countries, Sweden has no problem looking to newcomers to boost the nation’s foreign trade.

Swedish footballer Zlatan Ibrahimović, the son of Croatian and Bosnian immigrants

opping off a 20-year surge of immigrants with a new national record last year, Sweden issued nearly 110,000 resident permits in 2012. The year saw the highest annual number of immigrants on record, according to the Swedish Migration Board (Migrationsverket). At the northern edge of Europe, Sweden’s population of 9.5 million is now peppered with 200 different nationalities with the largest group (170,000) coming from neighboring Finland. Measured by surface and gross domestic product (GDP), Sweden, the largest of the three countries on the Scandinavian peninsula, offers an attractive destination paired with generous immigration regulations. Ranked 10th in the 2011 United Nations Human Development Index (UNHDI), which measures life expectancy, educational attainment and income, the country is a magnet for foreigners who readily flock to the home of famed pop group ABBA. In 2009, migrants accounted for 14.1% of the population – up from 9.1% in 1990. This is significantly more than Sweden’s neighbors Norway (10.0%) and Finland (4.2%), but less than European frontrunners Switzerland (23.2%) and Luxembourg (35.2%). Sweden’s hospitality is national policy. Both parliament and regeringskansliet, the government, pursue a migration policy that protects the right to asylum and facilitates freedom of movement across borders. “An attitude of openness is among our top priorities as well as a starting point in both Swedish trade and migration policy,” the Minister of Trade, Ewa Björling, told PROJECT M. “Regarding specific skills, our population is too small to satisfy the labor demand of Swedish companies. We need more knowledge and more skills, as employers often experience difficulties in filling new positions, and immigrants become a crucial prerequisite for Sweden’s economic growth,” Björling explains. The lack of workers will become more pressing as the Swedish population ages, albeit moderately. The country’s old-age dependency will rise from 28 (2010) to 42 (2050), the UN projects. Up until 2025, 1.6 million workers are expected to retire, of which 44% are public-sector employees. Both Statistics Sweden and the Public Employment Service are expecting difficulties recruiting enough nurses, dentists and medical doctors. Despite a fertility rate of 1.9, slightly below the 2.1 mark needed to keep population size constant, Sweden’s population is expected

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to rise to 11.6 million by 2060, according to Sweden Statistics – largely thanks to immigration. UNIQUELY QUALIFIED As workers support a growing number of retirees, Björling is concerned about the sustainability of Swedish welfare systems. “A key question is whether migration can be a remedy to the demographic challenge, and my answer is a clear ‘Yes.’ It is a key component in Sweden’s policies to achieve growth in the mid- to long term,” Björling explains. A far-reaching reform to immigration law in 2008, giving residency to everybody with a valid employment contract, only marginally increased the inflow of foreigners, by 15,000 people in 2010. “While the numbers are not extraordinary, these immigrants with their specific skill set stimulate Swedish society and foreign trade in particular,” Björling says. For evidence, she points to a study published in Ekonomisk Debatt (2009) showing that an increase in the number of people born abroad by some 12,000 individuals would lead to an increase in exports by as much as 7 billion Swedish kronor ($1 billion). “Foreign-born people are uniquely qualified to stimulate trade between their present country of residence and their country of origin,” writes Andreas Hatzigeorgiou, political adviser to Björling, in the Journal of Economic Integration (2010). Based on trade and migration data for Sweden and 180 foreign countries between 2002 and 2007, Hatzigeorgiou points to a statistically strong, positive and robust link between migration and increased trade flows. Consequently, immigration can be used as an instrument for increased foreign trade, Hatzigeorgiou argues. However, the argument does not ring true with the general population. Public sentiment turned noticeably hostile towards newcomers in the 2010 elections, when anti-immigrant party Sweden Democrats gained enough votes to enter the national parliament. Immigration’s exact economic value is also debated among academics and experts. While the destination country may benefit, the country of origin may suffer a loss it can ill afford. Then too, the relatively small immigration flow into the destination country is usually nowhere near enough to replace the aging workforce. In industrialized countries, immigration would have to be increased substantially to achieve this.

At home in Sweden: young Zlatan Ibrahimović in 2000

for Western economies, of admitting significantly larger numbers of migrants in the foreseeable future, is poor.” Professor of economics Jan Ekberg (Linneaus University) calculated immigrants’ contribution to the Swedish welfare system and found their impact negligible. “The positive net contribution to the public sector from the additional population is rather small even with good integration in the labor market,” he wrote in the peer reviewed European Journal of Population (2011). Ekberg points to the fact that not only public revenues, but also expenses rise with a growing population. “The yearly positive/negative net contribution effect is less than 1% of GDP for most of the years.” In 2009, Ekberg presented his findings to the Ministry of Finance and two years later to parliament, but saw them ignored by parts of the political caste. “There may be reasons for immigration, for example humanitarian, but the economic reasons are not very strong,” Ekberg told PROJECT M. “To ease the financial burden of welfare systems, we would be better to increase the employment rates among immigrants already in the country.” There is plenty of room to follow Ekberg’s recommendation. While 80% of the working age Swedes are employed, only 65% of the foreign born are, he says.

E WA B J Ö R L I N G

NEGLIGIBLE IMPACT According to estimates, countries like Denmark or the United Kingdom “may have to double immigration rates to offset the impact of demographic change,” George Magnus writes in The Age of Aging (2009). “The realpolitik outlook

A dental surgeon by training, Ewa Björling became minister for trade in 2007 after being a member of the Committee on Foreign Affairs from 2002 to 2007. Prior to her political appointments she was associate professor at Karolinska Institutet.

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Global oppor tunities

FINANCIAL REPRESSION IN ASIA Often referred to as “taxation by stealth,” financial repression has a long, and arguably even honorable, history of helping developing Asian economies focus financial resources in order to develop and prosper.

ow the wheel turns. Recently Gao Xiqing, president of China’s giant sovereign-wealth fund, China Investment Corporation, warned Japan against using its neighbors as a “garbage bin” by deliberately devaluing the yen. In doing so he added his voice to growing concerns that efforts by the United States, Europe and Japan to spark growth via quantitative easing, which effectively devalues currencies and increases export competitiveness, could devolve into a currency war. There is no better man to know. The artificial depressing of currency values to enhance exports is the very tool used over many years by China to grow its economy – and it worked. It is just one tool in a basket of measures taken to achieve growth or other specific economic objectives known collectively as ‘financial repression.’ It encompasses measures ranging from interest rate ceilings, liquidity ratios and bank reserve requirements to capital controls, credit ceilings and directives on credit allocation. Selective use of these tools in the past has helped to build strong economies in Hong Kong, a bastion of free enterprise, as well as Singapore, Japan, Indonesia and many other smaller Asian economies. By exercising controls, it has been possible for leaders in these countries to direct flows of capital, both domestically and inward investment, into favored areas of activity, be it into particular types of industrial growth, as in China, or into property, as in Singapore, and to manage currency values. A low interest rate is one such instrument that traditional Keynesian economics had long

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maintained would stimulate economic development, whether an economy is developed or not. However, in 1973 Stanford academic Ronald McKinnon challenged this wisdom. Defining financial repression as government financial policies strictly regulating interest rates, setting high reserve requirements on bank deposits and compulsory allocation of resources, he argued such measures have a negative effect on growth by discouraging both savings and investment, and thereby inhibiting efficient allocation of capital. ENDURING CURRENCY RISKS When McKinnon was writing 40 years ago financial repression was used extensively in Asian economies. However, the relationships between repression, liberalization and economic growth are by no means clear cut and the topic has been hotly debated ever since. Furthermore, financial repression is not only a phenomenon of developing nations, and history supports the notion that it typically occurs in developed countries when debt-toGDP levels are exceptionally high. Provided that economic growth, such as nominal GDP, can sustain a rate higher than the yield on bonds, the net effect is a reduction in the burden of public debt over time. But that is only true when investors are so unsure of achieving any returns that they are willing to endure zero or negative returns in order to preserve the minimal value of their capital. There is the likelihood that such a position cannot endure for any length of time. Today, policies of financial repression are increasingly being used by countries in

Meet in the middle: as Western economies increase regulation, some Asian countries, in particular China, are moving towards greater market freedom.

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the developed world as they seek to reduce the burden of massive public debt. The paradox is that at the same time, developing countries such as China are in the throes of leaving financial repression behind. As investors in today’s global marketplace are more willing than ever to endure currency risks, if they have to, in exchange for the prospect of achieving real returns, there is a real prospect of a flight of funds into higher growth emerging markets. “Our current yields on stock are artificially low,” says Tony Keogh, investment analyst and director of Irish-based Trinity Financial Services. “Yes, governments are intentionally interfering to get interest rates down. But that’s known. [US Federal Reserve Chairman] Bernanke has been quite clear about the use of interest rate policy and of ultra-loose monetary policy; in effect printing money. On that basis it’s wrong to suggest rates are ‘artificially’ low because everyone knows what’s being done.” Looking back over the past 100 years and more, Keogh says, shows the implied return for cash deposits for the next 20 years is around -0.8%, while government bonds of the same maturity have an expected real return of close to 0%. It is a policy approach in part intended to drive investment back into productive assets, which is now being pursued by the Bank of Japan and the Bank of England as well as other authorities in Europe. As mentioned above, this process of quantitative easing, which has been through three phases in the recent past, has been accompanied by increased fears of currency wars, most recently fueled by the measures taken by Japan. FINANCIAL REPRESSION “SELL-BY DATE” There are certainly similarities between the quantitative easing being adopted in the developed world today and historical financial repression in Asia, says economist Andrew Hunt of analysts Hunt Economics. In an Asian context there has been deliberate encouragement of a relatively narrow system which favors supply of resources to producers and governments over households. “It can be seen as a blunt but effective tool to channel funds into infrastructure,” he says, adding that “at a similar stage in our

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development we liked building cathedrals.” But, Hunt says, the limitations of financial repression are now being understood in both northern and southern Asian economies. “In Asia it’s rapidly getting to its sell-by date.” In Japan, for example, the Bank of Japan had long recognized that its models of financial regulation developed in the 1950s had no place in the 1990s. But it still found transition was easier to talk about than to do. In China, too, there are serious question marks, Hunt suggests, over the economy’s commitment to liberalization. “Things are changing, but there are still deep inefficiencies,” he notes. “It has ended up with a banking system that is not good at allocating resources because that is something it has not had to do in the past.” In Singapore, where savers were getting returns of 1-2% from the mid-1980s to mid1990s, this allowed the country to build up a huge infrastructure. However, Hunt says, the process went too far. “Financial repression can be great at times, when you are building industries, but not when you are trying to build nursing homes. It works well for most countries at some point in their history, but often it simply hangs around too long.” If India could provide itself with a stable economic system, he adds, he believes it could outperform China in terms of economic growth. His grounds for such a view? “India is much less financially repressed. It may be less effective than China at mass industrialization but it is a long-way ahead in terms of developing a service economy.” The point being that the ability to work efficiently in a liberalized market requires experience – something which it will take time for China to acquire as it moves away from repressive policies. INFLOWS INTO ASIA Raymond Chan, Allianz Chief Investment Officer, Asia Pacific, says the impact of financial repression in the West has clearly been seen in flows of funds into Asia. This has typically been reflected in the strength of real estate markets since around 2009. Hong Kong property, for example, has risen by 110% in the past five years. “If you look at how this can be afforded it’s hard to explain,” Chan says. “Most

IT WORKS WELL FOR MOST COUNTRIES AT SOME POINT IN THEIR HISTORY, BUT OFTEN IT SIMPLY HANGS AROUND TOO LONG. ANDREW HUNT

of it is due to excess liquidity in the system hoping to beat inflation and profit from capital gains on rising property prices.” It is a similar story in Singapore, where the authorities have recently imposed new taxes to try to cool the market, with limited success to date. But, says Chan, fears of a property boom and bust cycle like that seen in Western economies is not as great in Asia.

FURTHER I N F O R M AT I O N Global economic analysis at: hunteconomics.com

REFORM THE WAY TO GO Places like Hong Kong are used to peaks and troughs. Against the peak in 1997, for example, prices collapsed by 70% in 2003. If that happened in many other economies they would go belly up, but not in Hong Kong. “Even when we had massive negative equity, owners still did their best to service the debt. This time round there’s even less leverage in the system because the government has been more careful about down-payment requirements for people buying property,” Chan comments. Although the United States QE1 and QE2 programs saw money flowing into Asia, especially in the third quarter of 2012, QE3 coincided with large outflows from that country, with funds thought to have been largely destined to buy property in Australia and Canada. But QE3 also saw continued inflows of foreign funds into Thailand, the Philippines and India. Chan believes that the pressure is now squarely on China to drive onwards with

reforms of financial repression. “It is very difficult for us (in the West) to see how China is going to implement the policies it needs to. There’s going to be a lot of resistance to that and there are a lot of vested interests, but even if it involves a process of two steps forward and one step back the direction is clear. Reform is the way they have to go.” This is apparent, for example, in the desire by China to develop its bond market through planned removal of caps on deposits and lending rates. There is no question in Chan’s mind that 10 years from now, Western economies will be more regulated, while China’s will be less. Does that mean that Asia’s lessons on financial repression are not being learned – that history is doomed to repeat itself? Not necessarily, says Keogh. “There are still huge differences between economies in terms of how they operate and how they are regulated. But globalization of markets encourages flows across borders and, huge cultural differences notwithstanding, the trend is increasingly towards a consensus of policy approaches. “That may not be immediately obvious to us now and clearly there are ebbs and flows, but financial repression, in terms of control of financial agencies, is gradually being replaced by a somewhat more informed market regulation. Financial repression in terms of monetary policy, however – that’s another ball game entirely!”

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THE MALAYSIAN LESSON Recession in the early 1980s forced Malaysia to rethink its financial system. Three decades later, the country has no financial repression and is instead looking to secure recovery from the 2008 crisis through slow but stable growth.

By Esther Ong, chief investment officer, Allianz Malaysia Berhad, with John Stanley

lthough Malaysia is relatively liberal today in terms of its financial system, many weaknesses in the economy and financial system were revealed during the recession of the early 1980s. In 1982, the government stepped in to bring about more efficient management of the economy while reducing public sector involvement. Measures were introduced, including a soft loan scheme to boost smaller industries and prioritize lending guidelines for commercial banks, which helped reinvigorate the economy in the late 1980s. This focus on directing funding to priority areas continued for years, even as the liberalization of the country’s financial markets progressed. Yusof, Hussin, Alowi, Sing and Singh point out in Financial Reform – Theor y and Experience (1994) that Malaysia’s experience suggests governments in financially

Government control has given way to a more free-market approach in Singapore.

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repressed countries contemplating liberalization should first raise interest rates, ensure the health of banks, and build a strong central bank on both the regulatory and monetary side. This approach, including tight new laws and regulations that enabled the Central Bank to act quickly to give credibility and sustainability to financial reforms, was effective for Malaysia. Today, Malaysia has no financial repression, as we understand the term. Nominal interest rates are not held at artificially low levels to 'monetize' government debt, unlike in mature economies. The nominal rates are artificially depressed as a consequence of easy monetary conditions and unsustainable public debt has imposed significant costs on the private sector. SLUGGISH RECOVERY Malaysia never resorted to ‘deficit financing’ of the federal budget, where the central bank is a significant holder of government securities to help finance the budget deficit. Financing the deficit was tapped from non-inflationary sources, backed by flush liquidity in the financial system. However, Malaysia’s trade flows to the United States and Europe have been on a lower trajectory given the still sluggish recovery after the 2008-09 financial crisis. Export slack from mature economies has been partially compensated by intra-regional trade, led by China. A gradual global recovery should improve Malaysia’s trade flows to the Western world. Financial repression in developed economies is pushing flows into Asia in search of good returns. In Malaysia, there is strong interest in local properties as it remains one of the few south-east Asian countries with attractive property prices compared to Singapore, Hong Kong and even Jakarta, in Indonesia. Foreigners now own about 5% of the entire Malaysian property market. Buyers come from Singapore, Indonesia and China, with most preferring property in Johor Bahru and Klang Valley, and particularly Iskandar Malaysia because of its improved connectivity and accessibility as well as its proximity to Singapore.

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FROM THE LABS A survey highlights conf licting emotions among American women towards money, while the number of centenarians is set to jump dramatically, and elderly people are staying longer in the workforce.

49% C O N F L IC T I NG F I N A N C I A L E M O T I O N S

JA PA N E S E E C O N O M IC P O L IC Y

INTRODUCING ABENOMICS

D e s p i t e c o n s i d e r a b l e p r o g r e s s p r o f e s s i o n a l l y a n d f i n a n c i a l l y, a l m o s t half of American women fear becoming a ‘bag lady’ – a homeless woman who carries her belongings in a shopping bag – according to a survey by Allianz Life Insurance Company of North America. The poll of more than 2,200 women aged 25 to 75 with minimum household income of $30,000 a year highlighted a disconnect between their generally promising financial reality and deep-seated financial fears.

PA R T IC I PA T I O N R A T E O F PE O PL E AGE D 6 0 T O 6 4 Y E A R S

RETHINKING RETIREMENT?

The recently published survey Allianz Demographic Pulse revealed how the workforce participation rate of people aged 60-64 years has risen over the last 10 years. 2010

2000

Rise of elderly persons in the workforce

Switzerland South Korea United States

“ S i n c e h i s p a r t y ’ s l a n d s l i d e v i c t o r y a t the e l e c t i o n , ‘ A b e n o m i c s ’ h a s b e c o m e m ore sophisticated, and Prime Minister Abe himself has demonstrated his strong l e a d e r s h i p i n e c o n o m i c p o l i c y i n i t i a t i ves,” s a y s To m o y a M a s a n o , m a n a g i n g d i r e c tor in t h e P I M C O To k y o o f f i c e a n d h e a d o f p o r t f o l i o m a n a g e m e n t J a p a n a b o u t n ewly e l e c t e d J a p a n e s e P r i m e M i n i s t e r S h i n zō Abe. “Under the newly appointed l e a d e r s h i p , t h e B a n k o f J a p a n i s m a k i ng an i m p o r t a n t i d e o l o g i c a l s h i f t w i t h d e c i sive policy actions.”

Germany Spain 10 0 C LU B I S B O O M I NG

Greece Italy 10%

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TOO LIT TLE, TOO L ATE “Most people start planning for retirement too late and underestimate the financial needs that will be involved,” said Allianz CEO Michael D i e k m a n n i n a r e c e n t i n t e r v i e w. “ G e t t i n g s t a r t e d e a r l y, w i t h a n a c t i v e l y m a n a g e d investment portfolio, is the best strategy in a difficult environment like this.”

DI TCHING T HE DOLL A R T h e U S d o l l a r c o n t i n u e s t o b e t h e w o r l d ’ s p r i m a r y r e s e r v e c u r r e n c y, b u t i t w i l l b e l e s s d o m i n a n t i n t h e f u t u r e , s a y s S c o t t A . M a t h e r, managing director of the PIMCO Newport Beach, California, office and head of global portfolio management. “Other economies are growing more quickly with less reliance on debt. It makes little sense to us to h o l d a l l o f o n e ’ s w e a l t h i n t h e U S d o l l a r, a c u r r e n c y w e s e e l o s i n g value over the long term.”

There are currently around 343,000 centenarians worldwide, according to UN estimates. By 2050, this figure is likely to h a v e r i s e n t o n e a r l y 1 0 t i m e s a s m a n y. Societal aging will not only cause a further shift in the relationship between people in work and pensioners, but will also mean a change in the age structures within companies.

3.2 MILLION CENTENARIANS BY 2050

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SLOWING THE PACE Allowing institutional equity investors to be more patient would give them the power to transform financial market behavior, and in turn, the economy, argues one British academic.

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Time is all we need: John Kay advocates a shift away from investment shorttermism

arly on in his report into UK equity markets,1 Professor John Kay recalls one of the many tales written about Ulysses in Homer’s Odyssey. At one stage on his epic journey home to the island of Ithaca, the Greek king orders the sailors of his ship to tie him to its mast, so that he can avoid the temptation of the beautiful and luring song of the sirens. He knows that without help, he is not able to resist joining the mythical creatures and being led to certain death. Sadly, Kay goes on to argue, efforts to resist instant gratification have all but disappeared from the UK’s equity investment chain. From asset holders to investment managers, to company boards and all the middlemen in between, a constant focus on share prices and immediate results has led to chronic investment short-termism. The United Kingdom, in fact, serves as a warning to others of the dangers of short-termism. “Britain is at the extreme in terms of the fragmentation of shareholding,” says Kay. This fragmentation, he concludes, is a symptom of an equity market that is no longer fit for purpose. In his report, Kay blames short-termism for having fundamentally altered the role that equities now play in the wider economy. “What came as a shock to me is the extent to which the primary equity market was just irrelevant – that new equity is not a means by which business finances itself anymore,” he says. REINSTATING A SLOWER PACE Kay’s review, commissioned by the UK government, is part of an effort to facilitate a rebirth of this function, so that patient and committed equity investment plays its role in promoting long-term growth to everyone’s benefit. As he writes in the report, “British companies will earn the returns on investment which are necessary to pay our pensions and enable us to achieve our long-term financial goals”2 if this crucial link is restored. Some well-intentioned but counterproductive accounting and funding regulation is partly to blame for the creation of short investment time frames. Pension funds in particular are forced to put great faith in diversification and liquidity today. But the visiting professor of economics at the London School of Economics identifies the rise of a culture of trading and transactions, to the detriment of relationships between investors and companies, as the real culprit. “Everything follows in one way or another from that,” he says. Kay describes the development of this culture as a cumulative process, driven by the rise of US investment banks and accelerated by the deregulation of financial markets from the 1970s to 1990s. This has led to a

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proliferation of stock pickers, who, in order to spread their risk and differentiate themselves from the competition, have developed intricate strategies involving hedging positions and diversification. The knock-on effect, however, has been that pension fund clients have not kept on top of the latest developments and struggled to choose one manager over another. To counter this, a growing number of consultants have had to enter the equation. And advisers, Kay believes, by lengthening the investment chain, have placed investors at a further distance from their investee companies. So there is less of an incentive to engage with companies (due to investors looking for positions that provide easy exits and a large spread of investments to mitigate risk), and a diminished ability to do so due to the number of managers and consultants involved in the process. Consequently, company boards are now virtually at the mercy of ‘the markets,’ a blanket term for a mass of faceless investors who show no clear confidence – or even interest – in their long-term business plans. Such insecurity has led to directors taking a lot more notice of their standing in the financial markets. Kay highlights the growth of industry consolidation as one aspect of this greater attention. The hyperactivity of the trading floor can be mirrored in company boardrooms at times, he says, during periods of intense searching for suitable mergers or acquisitions. This hyperactivity also manifests itself in frequent internal reorganization, which usually does nothing to grow a company’s basic business. Asset managers, therefore, are playing a ‘zero-sum’ game. Not only are their activities not improving the performance of the many companies that they are investing clients’ capital in, but they are also not delivering long-term value for investors. NEW-AGE OR OLD-WORLD VIEW Kay’s remedy for the UK’s malaise is based on a new era of trust, among investors, managers and companies. Ushering in such a new age involves, among other proposals, companies phasing out the process of managing short-term earnings expectations and announcements; an application of common fiduciary standards to all parts of the investment chain; long-term pay and share incentives for asset managers and board directors; a diminished role for consultants; and a relaxation of risk assessment and valuation models. It also means changing the UK’s Stewardship Code, 3 so that it includes a focus on strategic issues. “[We need] the kind of relationships where asset holders are more comfortable with investment managers and are

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able to say ‘go away for three years and then tell us how you’ve done,’ instead of wanting to monitor – and being under pressure to monitor – monthly and quarterly performance figures,” says Kay. This would then allow managers to go away and cultivate the sort of mutually beneficial connections with companies that the report calls for. In order for these connections to be deep and meaningful, however, they have to be few in number, argues Kay. This is where investors such as pension funds hold real power. If they demand that assets are allocated to smaller groups of shares, much as Ulysses demanded to be tied to a mast, then the markets will have to respond. But this call to reduce stock fragmentation has sparked some of the strongest criticism of his report. One detractor, Professor Gordon Clark from Oxford University (see pages 31-33), has gone on record to say that Kay’s push for a smaller concentration of stocks was based on an understanding of fiduciary duty that is stuck in the 19th century. Such a backward step would, he said, leave smaller listed companies neglected and mean that smallerscale investors would miss out on cost-effective investment in the global equity market. A CHANGE IN THE AIR In his defense, Kay claims that the number of stocks you need in a portfolio to achieve “almost all the benefits of diversification” is actually quite small. And as for being guilty of nostalgia, he says that his emphasis on avoiding conflicts of interest and putting client interests first, are concepts that are “fundamental and enduring.” “Most asset managers would actually prefer to do the kind of job that is described in the report,” he maintains. “They’ve been trapped into a dysfunctional world that they didn’t particularly want to be in.” What’s more, it’s a world that the wider population is now paying more attention to. “The public at large and politicians have begun to look at the problems and the culture of the financial services industry,” says Kay. The age of short-termism therefore, may soon be coming to an end.

1 The Ka y Re vie w of UK Equit y Market s and Long-Term Decision Making, Jul y 2012. bis.gov.uk /as set s/biscore/busines s-law/ doc s/k /12-917-kay-rev iew- of- e quit y-market s-f inal-repor t .pdf 2 Ibid, page 5 3 The UK Stewardship Code was set up by the UK’s Financial Repor ting Council in order to improve engagement bet ween institutional investor s and companies – see frc.org.uk

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INDIA’S ‘MISSED CALL’ ECONOMY The problems hitting India’s telecom market in recent years are symptomatic of the nation as a whole, writes CRISIL senior director and chief economist, Dharmakirti Joshi.

By Dharmakirti Joshi

DHARMAKIRTI JOSHI Dharmakirti Joshi is the senior director and chief economist at CRISIL, a global analytical company providing ratings and risk and policy advisory services. In a March 2012 review, The Economist described CRISIL as “an impressive outfit,” noting that half its sales now come from abroad.

henever my driver wants to reach me, he dials my number and then hangs up. A missed call shows on my phone and I call back. There is an unwritten code of conduct here. Receiving calls in India is free, so he is essentially sending a poor person’s ‘text message’ to tell me to call back. I return the call, covering the cost, and we are able to communicate efficiently. This is not just a quirk of my driver. It is used across the country by many of the 600 million individual cell-phone users to let friends know they have arrived at a meeting point or inform them that a prearranged action has been completed. Increasingly, it is being incorporated into business. THE SPIRIT OF INNOVATION Small businesses send a missed call to vendors to indicate they need deliveries, local shops send a missed call to customers to let them know goods are ready, fishermen use a missed call to inform buyers they are on the way back to the shore. It is even being incorporated into mobile applications and services as a standard type of messaging. Far from indicating a dysfunctional economy, this behavior, which has been called the ‘missed call’ economy, is an indication of the spirit of practical innovation and untapped strength that underpins India. A decade ago, less than 37 million people had a phone of any kind. Today, every second Indian in a population of 1.2 billion has a mobile. * After the reforms of the late 1990s, the Indian telecom industry underwent rapid

market liberalization and growth. It is now amongst the world’s most competitive, cheapest and fastest-growing telecom markets. It is an amazing success. Telecom prices dropped by 8-10% per year for the last 10 years, which helped spur the growth of India’s economy, and the access to cheap communications made the life of the nation’s citizens easier in so many ways. However, the industry faces challenges ahead. Coverage in metro and urban markets is saturated, leaving little scope for new customer acquisition. Other issues concern lack of proper telecom infrastructure, power shortages and a shortage of trained personnel. A decision last February by the Supreme Court saw 122 second-generation mobile permits canceled following a report by the auditor-general of India that said they were sold at “unbelievably low prices.” The decision threw in doubt billions of dollars of investment by international companies. A former telecommunications minister was arrested and later released in a flurry of corruption charges involving former bureaucrats and a few company directors. SYMPTOMATIC DEVELOPMENTS The controversy has affected India’s international reputation. Investment is only cautiously proceeding, while end users can expect rising costs due to license fee system restructuring. An industry that had once seemed to represent all the booming promise of India’s economy now seems symptomatic of its malaise.

* T here are ac tuall y 9 0 6 million mobile subscriber s, but many have multiple phones. Source: Telecom Regulator y Authorit y of India, The Indian Telecom Ser vices Performance Indicators, July-September 2012.

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India may be full of promise, but challenges remain. To take full advantage of a golden opportunity, improvements must be made.

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Until 2008, India’s economy roared ahead at close to 9% a year, but the shock of the Lehman bankruptcy rippled around the world. In India, it punctuated confidence, and GDP fell sharply to 6.7%. Today, the global economy is not contracting. Rather, it is chugging along – but India’s GDP growth is languishing at 5%. What this means is that it is not global factors alone pulling India down. One local factor is high consumer price inflation, which has been in double digits since 2009. People say this is cyclical, but it has become more entrenched and structural in nature. The reason is government fiscal policy, which is driving consumption and not raising investment. BUREAUCRATIC BOTTLENECKS One example is agriculture. The government has implemented a welfare scheme (Mahatma Gandhi National Rural Employment Guarantee Act) that guarantees employment of a minimum of 150 days a year at an inflation-indexed rate. This lifted unskilled labor wages in rural areas, which have risen at near 20% per year in the last 3-4 years. With the greater purchasing power, people are demanding more food and more protein. The problem is that supply is stagnant, so prices are rising, which is making food less affordable. Food inflation has averaged over 10% in the past five years, as compared with 4.7% in the preceding decade. This surge in food inflation has led to high overall inflation which has consistently stayed above the central-bank target of 5% in the last seven years. High inflation has become a barrier to growth; unlike the rest of Asia, the Indian Central Bank is unable to cut rates to encourage investment to boost the wider economy. A second problem is global. We have realized that we are not insulated, that we are all interconnected. So, if the global economy is not doing well, our exports don’t perform. India’s exports are negative right now: exports to the 27 countries of the European Union are down 9%. Because 17% of our exports go to the

EU, this is clearly shaving percentage points off GDP growth (January-September 2012). Yet, while these are contributory reasons, perhaps the most important one for the slowdown is that bureaucratic bottlenecks in India have become amplified. Corruption is a significant issue, and numerous powerful people, including former government ministers, have spent time behind bars. In an environment where governance is being questioned, the bureaucratic process becomes more cautious in its decision-making, which impairs the already slow clearance rate for projects. India today faces a cocktail of issues. Domestically, we have a cautious bureaucracy, high interest rates, and an environment not favorable to investors. Consequently, nominal private corporate investments fell by 13% in 2011-12, and CRISIL expects these to fall by another 35% in the fiscal year 2012-13 (beginning April 2012). To address this, politicians need to focus more on creating investment, rather than consumption, to help combat inflation. Last year the government announced steps to tame the fiscal deficit, speed up private investments through the formation of a cabinet committee, and open up the retail sector to direct foreign investments. The recent central government budget aims to cut the fiscal deficit further. THE PERILS OF A MISSED OPPORTUNITY The country also needs to address issues ranging from mining to land acquisition and taxation, including a proposed GST that would simplify the indirect regime, provide business with greater clarity as to the rules of the game and encourage private investment. Finally, improving India’s physical infrastructure and agricultural productivity will raise its growth potential and lower inflation. Unless India does this, it will fall short of the potential that a young, dynamic nation of 1.2 billion increasingly educated and connected inhabitants offers. The challenge for India now is to ensure is that a missed-call economy doesn’t become one of missed opportunity.

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SPOILS OF THE EARTH In the Jiangxi Province of southern China, the mining of rare earths has caused a boom in the local economy. But as demand for the valuable elements increases, environmental and political challenges arise.

By Clifford Coonan in Beijing, Greg Langley in Munich

n a land once almost a synonym for poverty, the Jiangxi Province in southern China was once a place of extreme misery. When then General Secretary of the Communist Party Hu Yaobang visited Jiangxi in the 1980s, he was deeply affected by the poverty of the local people, even though they were living on top of what he saw as “a golden floor.” Jiangxi is rich in minerals – tungsten, copper, silver, gold and rare earths – so it should have been a prosperous place. To enable locals to take advantage of the bounty, Hu overturned a ban preventing mining from being undertaken by anyone other than state entities, inspiring a boom whose reverberations are still felt today. “I can’t bear that people are sent to war but are left to beg for food,” commented Hu. ELEMENTS GAINING DEMAND Rare earths are 17 elements buried deep in the middle of the periodic table. Most people had never heard of them until they became a bargaining chip in a dispute with Japan over a detained Chinese fishing trawler in 2010. The prices of rare earths spiked high at this time, but have since fallen dramatically as the global economic downturn hit demand (see PROJECT M #08 ‘Our rare earth’), yet China’s stringent control over the resources using caps on production and export quotas still riles many of China’s trading partners. And undoubtedly rare earths will again become an issue as worldwide demand for at least some is soon set to outstrip supply. Rare earths are used in hundreds of modern products because their electrical, optical and thermal properties enhance final results. These elements are found throughout China’s provinces. They were first extracted in the 1950s at the Bayan Obo iron and steel mines in Inner Mongolia. Jiangxi is particularly rich in rare earths. Some 2.89 million tons of proven reserves of ion-absorbed-type rare earth elements – 40% of the nation’s total – are found near the city of Ganzhou.

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The decision by General Secretary Hu inspired a flurry of activity as small family and collective companies began mining. At its peak, Ganzhou alone had 1,035 companies with rare-earth-mining licenses. Cheap labor costs provided a significant competitive advantage for China, and its rare earths flooded the market in the 1990s, causing prices worldwide to plunge. Competitors such as Molycorp, whose Californian Mountain Pass mine had dominated rare-earth production since the 1940s, either reduced production or were driven entirely out of business. In 1992, during a visit to Bayan Obo, former leader Deng Xiaoping outlined China’s strategy: “There is oil in the Middle East; there is rare earth in China.” DOMINATING THE MARKET – AT A COST Although China has only 36% of the world’s known reserves of rare earths, it currently supplies more than 90% of the global supply, according to the Chinese Ministry of Commerce. But China’s monopoly grew at the expense of the environment. Extracting rare earths is complex and involves acids and solvents during separation. When mining standards are lax, chemicals can enter rivers and water tables. The water then poisons farmlands and fish farms. In addition, slurry tailings from rare earth ores can be mildly radioactive due to the presence of thorium and uranium. The environmental havoc caused in China can be seen in Beitou, a town in southeast Jiangxi. As reported in the People’s Daily (‘China’s rare earth campaign targets environmental protection,’ 16 September 2010), mining started there 22 years ago, quickly turning a tranquil rural environment into a moonscape of holes and toxic chemicals. Liu Shengyuan, a 45-year-old farmer, was quoted: “We used to drink water from the rivers, but now even fish and shrimp cannot survive in the water.” Professor Li Lemin, director of the academic association of the State Key Laboratory of Rare Earth Materials

Marks of man: extraction of rare earths in China comes at a price, above all for the environment.

Since China allowed non-state entities to mine rare earths, the industry as a whole has been booming.

In his cabin near Ganzhou, a worker checks the acidity of materials with pH results in his notebook.

NOT AS COMMON AS DIRT Rare earths (lanthanides – elements 57 to 71 in the periodic table – plus yttrium and scandium) are more common than the name implies. Worldwide reserves are considered sufficient to last 800 years at current consumption rates, but the challenge is finding concentrated deposits suitable for extraction and separation. Rare earths are divided into light and heavy elements. While light rare earths are abundant, a critical shortfall in heavy rare earths is emerging, particularly in dysprosium and terbium because of their use in the growing green-energy field. China mines more than 99% of the world’s supply of these elements, with production taking place in northern Guangdong and Jiangxi Province. Violent criminal gangs have taken to illegal mining – which can be more lucrative than drug smuggling. Smugglers mix rare earths with steel and then export the steel composites. The processes are reversed overseas and the elements recovered. According to statistics, the amount of rare earths smuggled out of China in 2011 was 1.2 times the amount legally exported, Ma Rongzhang, secretary-general of the Association of China Rare Earth Industry, told the China Daily newspaper. This means nearly 22,320 tons of rare earths were smuggled out of China that year.

Rare earth precipitate is baked at almost 1,000°C before being packed into drums for delivery.

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Chemistry and Applications, believes that environmental costs will inevitably be factored into rare-earth costs, which could drive prices higher in the long term. “It is not easy to balance the needs of commercial mining with environmental issues, but that is what we are trying to do. Since most of the current smelting-separation factories don’t qualify under environmental protection standards, improving environmental issues will be one of the key points related with rare-earth exploitation,” says Li. “The pollution caused by mining rare earths is different from other industries like, say, a paper mill, because it is chemical pollution plus radioactive pollution and the situation is more severe.” THE MEANS TO A MORE PROSPEROUS END A situation has emerged where, as a means of raising citizens from poverty, China had been selling rare earth dirt cheap. The West benefited from the arrangement; with China doing the dirty, toxic, radioactive work, Western consumers enjoyed inexpensive high-tech products. But as China transforms from a low-cost manufacturing hub and producer of raw material to a supplier of quality finished products, it was inevitable that attention turned to rare earths. To gain greater value from rare earths and address the ecological damage of unregulated mining, Beijing has taken action against heavily polluting producers, hiked export taxes from 15% to 25%, introduced OPEC-style production caps and launched a crackdown on smugglers. The government is also encouraging mergers and acquisitions so the number of rare-earth firms reduces from 90 to 20 by 2015. These actions saw prices climb significantly. For example, the price of neodymium oxide, used in magnets in BlackBerrys, surged from $30 to $125 per kilogram in 2010. But it was an incident late in 2010 that pushed rare earths into the headlines and saw prices rocket. A Chinese fishing captain, whose boat collided with Japanese patrol boats near disputed islands in the South China Sea, was detained by Japan. This resulted in a major diplomatic dispute with China launching an unofficial embargo of rare earths on Japan until the captain was released. All through 2011, rare-earth prices fluctuated wildly, rising strongly in the middle of the year after the government tried to consolidate the sector, but then falling back sharply on the back of weaker demand. By the end of the year, China had only exported 14,750 tons of rare earths, or 49% of the full-year official limit.

Whether triggered by the South China Sea incident or not, rare earths were always destined to become an issue. Not only is China the biggest producer of rare earths, it is also the largest consumer, using up some 51% of the world’s annual production. FINITE RESOURCES Clean technology is one factor driving worldwide demand for rare earths. Two tons of neodymium is needed for each wind turbine. Lanthanum is a major ingredient for hybrid car batteries, and terbium is vital for low-energy light bulbs. Given China’s vow to switch to green technology, it is clear that the country could struggle to meet its own requirements, let alone fulfill global needs. Of particular concern are medium and heavy rare earths. The Chinese Ministry of Commerce has said Chinese supplies of critical elements like europium and terbium might only last another 15-20 years. Overseas firms are shipping rare earths to offset China’s stranglehold on the market, so supplies from companies like American firm Molycorp and Australia’s Lynas Corporation may put further pressure on prices. However, this could be counterbalanced by China’s decision last year to set tough emission limits on 15 pollutants for all industry players, including miners and smelters of rare-earth alloys. The rules are due to take effect from October for new projects, and existing players have until the beginning of 2014 to comply with new standards. Wang Caifeng, a member of a government body aimed at guiding the domestic rare-earths industry, told the 21st Century Business Herald: “For sure this will influence the rare-earth producers and smelting separation companies, but I think there will be a transition period. It cannot be that once the standard is brought out, everyone stops producing. And I think it’s better to give those companies two or three years to change,” said Wang. Yet, Japan and the United States still see China as unfairly restricting exports. The matter could end up being fought out in the World Trade Organization, but regardless of the outcome, it will not change the fact that supplies of some rare-earth elements will be increasingly scarce in years to come. If China and the world are serious about converting to a low-carbon environment, then addressing these shortages by finding and better deploying alternative supplies will be critical to the development of a new generation of greenenergy technologies.

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